Wolinsky v. MNR, 90 DTC 1854, [1990] 2 CTC 2417 (TCC)

Mogan, T.C.J.:—The appeals of Herbert Liffman and David Wolinsky were heard together on common evidence. In 1980, Central Canadian Properties Ltd. ("CCP") loaned to each appellant the sum of $80,000. Identical promissory notes signed by the appellants provided for annual principal repayments of $8,000 plus interestat the rate of 11 per cent per annum payable on an annual basis. The appellants did not make any payments to CCP on account of principal or interest but the amounts owing each year with respect to interest were capitalized and added to the respective debt of each appellant. The issued shares of CCP were owned in equal portions by Mr. Liffman, Mr. Wolinsky and an uncle of Mr. Wolinsky.

When reassessing the appellants for the 1980 taxation year, the respondent included the full amount of the $80,000 loan in the income of each appellant for that year. The respondent relies on subsection 15(2) of the Income Tax Act which at that time stated in part:

15. (2) Where a particular corporation . . . has made a loan to a person . . . who is a shareholder of the particular corporation . . . the amount thereof shall be included in computing the income for the year of the person to whom the loan was made unless

(a) the loan was made

(i) in the ordinary course of the lender's business and the lending of money was part of its ordinary business,

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

The basic issues in these appeals are (i) whether the $80,000 loans to the appellants were made in the ordinary course of CCP's business; and (ii) whether bona fide arrangements were made at the time of the loans for their repayment within a reasonable time. The respondent admits that the lending of money was part of CCP's ordinary business. There is a secondary issue concerning capitalized interest which the respondent included in the appellants' incomes for 1981 and 1982. The secondary issue will be considered later in these reasons.

The appellants are lawyers who practise together in a small partnership. Mr. Wolinsky, upon his call to the bar in 1965, joined his father in the practice of law. Mr. Liffman was called in 1967 and joined the Wolinskys in 1972. By 1980, the appellants were the only active partners and Mr. Wolinsky's father was semi-retired.

CCP was incorporated in 1970 to engage in the business of lending money. The persons who borrowed from CCP were primarily businessmen and land developers who were clients of the appellants’ law firm. On some loans CCP would have a mortgage as security; on others CCP would have a deposit of title; and on others CCP would have only a promissory note. Five schedules filed as exhibits show that from August 1,1975 to July 31, 1980 CCP had nine loans each secured by a mortgage. Interest charged on eight of those loans was in the range of 14 A per cent to 16 A per cent and interest on the ninth loan was prime plus 1 /2 per cent. It was not unusual for CCP to capitalize all or a portion of the interest on those nine loans. Most of those loans were repaid within two years.

There is no evidence to show who borrowed from CCP by delivering a deposit of title or by delivering only a promissory note; there is no evidence to show the interest charged on such loans; and there is no way of determining whether the interest charged on secured loans was lower or higher than interest charged on unsecured loans. There is no evidence of other loans providing for a ten-year repayment. The secured loans described in the five schedules apparently all started as short-term loans even though some of them dragged on for a number of years because the borrower could not repay in the short term.

On April 15, 1980, CCP loaned $160,000 to the appellants: $80,000 to Mr. Liffman and $80,000 to Mr. Wolinsky. CCP received two identical promissory notes from the appellants but did not receive any mortgage, deposit of title or other property as security for the loans. In my view, a promissory note is evidence of a loan and its terms but is not security for the loan.

The appellants control CCP. Therefore, it should have been easy for the appellants to produce documents from the records of CCP to answer the following questions: (i) to whom did CCP make arm's length unsecured loans in the period 1979-1980-1981; (ii) did any of those loans provide for a ten-year repayment; (iii) what rate of interest was charged on those loans; (iv) how did the rate of interest on CCP's unsecured arm's length loans compare with the rate of interest on its secured loans; (v) did CCP borrow $160,000 from its bank on April 15, 1980 to make the $80,000 loans to the appellants; (vi) what rate of interest was paid by CCP to its bank on its line of credit in April 1980 and over the preceding twelve months?

The above questions are all factual. The answers must be contained in the books and records of CCP. Answers to those questions are necessary to determine whether it was reasonable for CCP to charge 11 per cent on the $80,000 loans to the appellants having regard to the rate of interest charged by CCP on its other unsecured loans and the rate of interest payable by CCP to its bank on its line of credit.

A corporation engaged in the business of lending money will not ordinarily make a loan for a ten-year term at a fixed interest rate which is close to prime bank rate at the time of the loan. To prove that the loans from CCP to the appellants were made in the ordinary course of CCP's business, it was essential to prove the prime bank rate in April 1980. Neither appellant was able to state what the prime bank rate was in April 1980. Evidence concerning the prime bank rate in the period 1979-1980-1981 was, at best, vague.

In the pleadings, the appellants allege that the $80,000 loans were made in the ordinary course of CCP's business. The respondent denies that allegation and puts the appellant to the strict proof thereof. On this question of fact, the onus of proof was on the appellants. There is simply not enough evidence to determine whether the $80,000 loans to the appellants were made in the ordinary course of CCP's business. I therefore find that the appellants have failed to discharge the onus of proving that they satisfy the conditions in subparagraph 15(2)(a)(i) which, subject to proving bona fide arrangements for repayment, could have excluded the $80,000 loans from income.

Having decided that the appellants failed to satisfy the conditions in subparagraph 15(2)(a)(i), I am not required to decide the other basic issue concerning whether there were bona fide arrangements for repayment at the time of the loans. I should observe, however, that the evidence of such arrangements is not convincing. The fiscal period of the appellants’ law firm ends on the last day of February. For the fiscal period ending in February 1980, the gross fees declined from $255,000 in the prior year to $197,000; expenses increased from $138,000 to $152,000; and profit declined from $117,000 to $45,000. For the same fiscal period, the deficiency in the appellants' capital accounts in their partnership increased from $30,000 to $60,000 (approximate amounts).

The appellants both testified and stated that they did not know until December 1980 (upon receiving the audited financial statements of their partnership for fiscal 1980) how they had performed in that fiscal period. They had no full-time bookkeeper and the partnership financial records were inadequate. That testimony may be true but it does not satisfy the condition with respect to bona fide repayment arrangements. When the loans were made in April 1980, the appellants' law firm had suffered a 23 per cent decline in revenue and a ten per cent increase in expenses in the fiscal period which had just ended 45 days previously. The law firm owed the bank about $170,000. The funds borrowed from CCP were immediately injected into the law firm.

An arm's length lender of $160,000 in April 1980 would surely have required current information concerning the partnership fiscal period which had just ended. A superficial review of the billings would have disclosed the 23 per cent decline in revenue and the 60 per cent decline in profits. The amount (principal plus interest) which each appellant was required to pay to CCP in the first year of the loan exceeded the income of each appellant from their partnership for fiscal 1980. In these circumstances, CCP and the appellants should have doubted their ability to repay the $80,000 loans in accordance with the terms of the promissory notes.

Soon after obtaining the loans, the appellants lost money in an airport car rental business and in some rental properties. Also, Mr. Wolinsky lost money in an Orange Julius franchise. These losses were probably not foreseeable in April 1980 and they help to explain the appellants’ failure to make any payments of principal or interest on the $80,000 loans. The fact remains, however, that the appellants caused CCP to lend them $160,000 when the borrowing power of their law firm was stretched to the limit and their available capital was invested in other businesses and properties. In other words, they had virtually no personal liquidity at the time of the loans. These facts should have contributed to any doubts they might have had concerning their ability to pay down the loans with the income from their law firm.

When asked why they made no payments in respect of principal or interest on the loans, they stated that they simply did not have the funds, and any available cash went to creditors who exerted greater pressure than CCP. This evidence is directed to the bona fide of the repayment arrangements and raises the question as to whether, in April 1980, CCP was always going to be the last creditor to be paid. Without deciding this other basic issue, I will simply repeat that the evidence as to bona fide arrangements for repayment at the time of the loans is not convincing.

By notices of reassessment, the respondent added the following amounts to the appellants' reported incomes for the taxation years 1981 and 1982.

The above amounts represent interest owing on the $80,000 loans. The interest was not paid by either of the appellants but was capitalized in the books and records of CCP. Through the respondent's oversight, no amount was added to Mr. Wolinsky's income for 1981. The respondent, did, however, add the amount of $5,512.73 to Mr. Wolinsky's 1982 income with respect to interest owing in a loan identified as "Lindale" but, during the hearing, counsel agreed that the amount of $5,512.73 should be deleted from Mr. Wolinsky's 1982 income without regard to the Court's disposition of the other issues. The secondary issue, therefore, is whether the amounts of capitalized interest should be included in Mr. Liffman’s income for 1981 and in the incomes of both appellants for 1982.

The respondent relies on subsection 15(1) of the Income Tax Act for Mr. Liffman’s 1981 taxation year and on subsection 15(2) for the appellants’ 1982 taxation year. The respondent also relies on section 80.4. In my view, section 80.4 cannot apply to 1981 or 1982 because the $80,000 principal amounts of the loans were correctly included in computing the respective incomes of the appellants for 1980. For 1981, subparagraph 80.4(2)(a)(ii) defined "excluded loan” to include "the portion of any loan included in computing the income of the individual to whom it was made". And under paragraph 80.4(1)(b), the deemed benefit did not apply to a shareholder who received an excluded loan. For 1982, section 80.4 had been amended to provide in paragraph (3)(b) that the deemed benefits in subsections (1) and (2) did not apply in respect of any loan that was included in computing the income of a person under the Act.

Only Mr. Liffman has appealed the 1981 taxation year when subsection 15(2) provided in part as follows:

15. (2) Where a particular corporation . . . has in a taxation year made a loan to a person who is a shareholder of the particular corporation, . . . the amount thereof shall be included in computing the income for the year of the person to whom the loan was made unless. . . .

For 1981, there is no amount to include in the income of a shareholder under subsection 15(2) unless the corporation has "made a loan”. There is a real distinction between "loan" and “debt”. A loan requires delivery of a sum of money from a lender to a borrower. A debt is simply a sum of money owing from one person to another. A debt can arise under contract without any loan as, for example, a purchaser's failure to pay the purchase price. Mr. Liffman’s failure to pay annual interest on the $80,000 amount in 1981 did not cause CCP to "make a loan" to Mr. Liffman but it did cause Mr. Liffman to become indebted to CCP under the terms of his promissory note. The concept of a shareholder becoming "indebted" to his corporation did not appear in subsection 15(2) until the 1982 taxation year. Therefore, subsection 15(2) does not support the respondent's assessment of Mr. Liffman for 1981.

The respondent also relies on subsection 15(1) to support his assessment of Mr. Liffman for 1981. It must be remembered that the amount under appeal for 1981 is interest at 11 per cent in the amount of $7,690.95 which was not paid but was Capitalized. In my view, subsection 15(1) does not apply to the amount of interest capitalized in 1981 for the following reasons. Under paragraph 15(1)(a), CCP did not make any payment to Mr. Liffman. Under paragraph 15(1)(b), no funds or property of CCP were appropriated. Rather, the amount of interest which Mr. Liffman should have paid in 1981 was not paid but was capitalized and added to the principal amount of his debt. And under paragraph 15(1)(c), no benefit or advantage was conferred because Mr. Liffman’s liability to CCP was increased by the amount of capitalized interest. Therefore, subsection 15(1) does not support the respondent's assessment of Mr. Liffman for 1981.

For 1982 and subsequent years, subsection 15(2) was amended to provide in part as follows:

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

The above wording is, without doubt, broad enough to support the respondent's reassessments for the 1982 taxation year in which capitalized interest of $8,800 was added to the reported income of each appellant. The requirement to pay annual interest at 11 per cent was one of the terms of the promissory notes. The failure to pay annual interest on the loans and the capitalization of such interest may not have caused either appellant to "receive a loan” from CCP with respect to such interest but it certainly caused each appellant to "become indebted” to CCP under the terms of his promissory note. Therefore, both appeals concerning the $8,800 amounts in 1982 are dismissed.

In conclusion, I would allow Mr. Liffman's appeal for 1981 but dismiss his appeal for 1980 and 1982. I would allow Mr. Wolinsky's appeal for 1982 with respect to the amount of $5,512.73 but dismiss it with respect to the amount of $8,800. And I would dismiss Mr. Wolinsky's appeal for 1980. There will be no order as to costs.

Appeal allowed in part.