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Citation: 2004TCC376
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Date: 20040730
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Docket: 2001-4291(IT)G
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BETWEEN:
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RÉAL BERNIER,
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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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[OFFICIAL
ENGLISH TRANSLATION]
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REASONS FOR JUDGMENT
Paris J.
[1] The Appellant is an
insurance broker and consultant, and he is the sole shareholder of a number of
companies. In 1998, he paid $29,755.33 in interest in connection with a line
of credit, and he claimed an equivalent deduction in calculating his business
income. The Minister of National Revenue disallowed the deduction, because the
interest had not been paid in connection with a loan used for the purpose of
earning income from a business or property. The Appellant also claimed capital
losses on a repayment made to the line of credit in 1998. The line of credit
was denominated in U.S. dollars, and the losses resulted from exchange rate
fluctuations between the U.S. dollar and the Canadian dollar. The Minister
disallowed the losses. Finally, penalties were imposed on the amounts
disallowed, pursuant to subsection 163(2) of the Income Tax Act (the
“Act”).
[2] The issues at bar
in this case are as follows:
Was the loan for which the Appellant paid
interest in 1998 used for the purpose of earning income from a business or
property?
Did the Appellant sustain losses in 1998
related to a foreign currency subject to subsection 39(2) of the Act? If so,
what is the amount of these losses?
Consequently, did the Appellant knowingly,
or in circumstances amounting to gross negligence, make a false statement or
omission in filing his income tax return for the 1998 taxation year?
Deduction of
interest
The Act
[3] In order to claim a
deduction for interest in the calculation of the income he earns from a
business or property, a taxpayer must meet the requirements set out in
paragraph 20(1)(c) of the Act, as follows:
20. (1) Notwithstanding paragraphs 18(1)(a),
18(1)(b) and 18(1)(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 on the method regularly followed by the taxpayer
in computing the taxpayer's 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),
[...]
[4] In order to justify
a deduction under this provision, a taxpayer must be able to demonstrate that
the money borrowed, on which the interest was paid, was used in an activity
that can be identified as an income-earning activity. The taxpayer must
demonstrate how the borrowed capital was used.
[5] It is not possible
to claim a deduction where the relationship between the borrowed funds and the
eligible use is merely indirect. The interest is deductible only where a
sufficiently direct relationship exists between the funds borrowed and the
actual eligible use. In this respect, the
Federal Court of Appeal says the following:
[...] Thus, even in
cases where the borrowed funds are used for a purpose that has the indirect
effect of enhancing the taxpayer's income-earning capacity, the interest
payments remain non-deductible. The income-earning purpose is simply too remote.
[6] It is necessary to
determine, based on the evidence filed in this case, whether the Appellant has
discharged his burden to demonstrate the existence of a direct relationship
between the funds borrowed and an eligible use during the 1998 taxation year.
Evidence
[7] The evidence shows that, in 1992, the
Appellant obtained a $375,000 line of credit denominated in U.S. dollars from
Financial International Advisors Ltd. (“FIA”). The company’s head office is
located in the Bahamas, but its operations are based in Phoenix, Arizona.
Any funds borrowed against the line of credit were to be repaid on November 30,
1996. The annual rate of interest was 7.5%.
[8] The Appellant testified that he arranged
this funding for the purpose of investing the money and paying the legal fees
incurred by the company, Agence J.W.E.R. Bernier Ltée (“Agence”), which was
involved in legal action. Agence expected to be awarded a substantial amount
in damages in the case. The Appellant stated that, without the line of
credit, he would have been forced to sell some of his investments to pay the
legal fees incurred by Agence.
[9] The Appellant stated that, in 1992, he
borrowed $370,000 (less a 5% processing fee retained by FIA) against the line
of credit. However, in his testimony, he also stated that he had left some of
the money on deposit with the FIA until he needed it in 1994.
[10] When asked to explain how he had used the
money, he indicated that he had loaned approximately $150,000 to Agence to
enable the company to acquire the Argenteuil building, for which he already held a second mortgage. The
first mortgagee had initiated foreclosure proceedings, and Agence was at risk
of losing its investment, unless it acquired the first mortgagee’s rights.
[11] Agence's financial statements show that
the company acquired the Argenteuil building for $151,304.33 and that this property still carried a
first mortgage of $149,431.64. These financial statements also show that Agence
incurred $9,201.19 in interest charges on this mortgage during its 1993
taxation year. The evidence does not support the Appellant’s claim whereby he
provided Agence with a $150,000 advance to discharge the first mortgage and
acquire the Argenteuil building
in late 1992.
[12] Nevertheless, Agence's financial
statements for the 1998 taxation year (including comparative data relating to
the 1997 taxation year) reveal that Agence no longer owned the Argenteuil
building, which had been disposed of prior to 1997. Consequently, even where I was satisfied that, in 1992 or 1993,
the Appellant used the funds from the line of credit to buy back the rights of
the first mortgagee, the funds could not have been used for that purpose in
1998, because the Argenteuil building had been disposed of a year earlier.
[13] The Appellant also claimed that he
invested $100,000 in a restaurant called Vert Blanc Rouge, and that he
had received the related interest. The Appellant filed an excerpt of the
working papers used by an Appeals Officer from the Canada
Customs and Revenue Agency (CCRA), pertaining to a reassessment the Appellant
received for the 1993 to 1995 taxation years. The deductibility of interest
on an alleged investment of $100,000 in Vert Blanc Rouge was being contested.
In this case, the deduction was allowed.
[14] In the documents before me, the only
indication of this 1998 investment appears in Gestion’s financial statements
for the 1998 taxation year, in which reference is made to a $13,383 mortgage
payable by Vert Blanc Rouge to Gestion. No document relating to the Appellant’s alleged loan, nor any
evidence to corroborate the loan, was filed. Therefore, I have insufficient
evidence to conclude that, in 1998, the Appellant used a portion of the funds
from the line of credit to invest personally in Vert Blanc Rouge, or that the
restaurant owed money to the Appellant personally, rather than to one of his
companies.
[15] The Appellant also
claimed that an additional $168,000 drawdown was made from the line of credit
to pay Agence’s legal fees related to the litigation in 1994 and 1995. He
considered these amounts to be advances that he had made to Agence.
[16] The evidence also
shows that Agence was successful in this case, and it was awarded $366,864 in
damages. The Appellant claimed that Agence received the money in 1995 and that
it repaid FIA in 1996. In Agence’s financial statements for the 1998
and 1999
taxation years, the only entries that can be identified as debts to the
Appellant are the sums of $11,855 and $14,633 respectively, listed as
directors’ debts. All of Agence’s other debts were payable to an “affiliated
company” in 1998 and to a “private company” in 1999. It appears that all of
the advances the Appellant made to Agence prior to 1996 have been repaid. It
is not possible for me to conclude, based on the evidence before me, that the
drawdowns from the line of credit with the FIA were invested in Agence by the
Appellant after 1996.
[17] The Appellant also
testified that he had invested money in another company for which he was the
sole shareholder: Magazine l’agent de voyage Inc. (“Magazine”). He referred to
Magazine’s financial statements for the year ended July 31, 1997, which show advances
totalling $71,568 that the company owed to “third parties”; he also referred to
the financial statements for the period ended July 31, 1999, which show debts
totalling $55,927 owed to an affiliated company. The Appellant claimed that
he, himself, was the “affiliated company” and the “third parties” identified in
the statements.
[18] However, the
financial statements for Gestion, owned by the Appellant, show loans from
Gestion to Magazine, whose outstanding debt totalled $58,159 on January 31,
1997, and $77,995 on January 31, 1998. Although the dates indicated in
Gestion’s financial statements do not correspond exactly to those that appear
in Magazine’s financial statements, it is clear to me that during these years
most, if not all, of Magazine’s debts were owed to Gestion, rather than to the
Appellant personally.
[19] The Appellant stated
that he had made additional drawdowns to advance the sum of $244,000 to another
one of his companies, Société de Gestion Réal Bernier Inc. (“Gestion”).
Gestion was incorporated in 1994, and its financial statements for 1995 to 1998
taxation years were filed in evidence. These statements show that the funds
advanced by the Appellant totalled $244,081.63, $245,776.41, $371,847, and $244,338 on January 31, 1995,
1996, 1997, and 1998, respectively.
The Appellant did not specify the dates on which the advances were made, and he
did not document any relationship whatsoever between these advances of funds
and the drawdowns from the line of credit.
Position of the
parties
[20] Counsel for the
Respondent did not challenge the Appellant’s drawdown from the FIA line of
credit to pay the interest owing in 1998, but she argued that it was not
possible to determine that the funds borrowed had been used by the Appellant
for income-generating activities.
[21] Counsel for the
Appellant argued that a direct relationship exists between the Appellant’s
drawdowns from the line of credit and his investments. He added that, at any
rate, the Act no longer requires that a direct relationship be strictly
demonstrated between the funds borrowed and an income-generating activity or
objective, such that the deduction of interest should be allowed, even where
the Court concludes that the Appellant was not able to establish a specific
relationship between the drawdowns and the use of the funds in 1998. He argued
that, at the very least, there was evidence that the Appellant had used the
borrowed money indirectly to generate income from his investments, which made
him eligible for the deductions claimed. He also argued that the deduction
should be allowed, because the Appellant had been authorized in the past to
deduct the interest related to the line of credit.
Analysis
[22] It is my opinion
that the evidence filed by the Appellant does not, in any way, account for the
funds borrowed by the Appellant from the line of credit. Neither the drawdowns
from nor the repayments to the line of credit have been documented.
[23] During
cross-examination, the Appellant was asked, on a number of occasions, to
provide details of the dates and amounts of the drawdowns he made from the line
of credit between 1992 and 1998, and the use of the funds. The Appellant’s
responses were vague; very few of his claims regarding the use of the funds
were corroborated by documentary evidence and none of them was corroborated by
other witnesses. No bank statements were filed to show the transfer of funds
drawn from the line of credit to other accounts. No transaction dates were
specified, and the years in which the Appellant claims he made various
investments remain unclear. Only one statement relating to the FIA line of
credit was filed, even though
the evidence showed that statements were sent to the Appellant every six
months, beginning in 1992. Moreover, there are a number of contradictions
between the Appellant’s testimony and the documents filed. Overall, I am not
satisfied that the evidence provided by the Appellant with respect to the use
of the funds is credible.
[24] It is my opinion
that the Appellant cannot establish a relationship between the drawdowns and
their specific use, let alone a direct and eligible use. The fact that he
invested money at the same time as he became indebted to the FIA by way of his
line of credit is not sufficient. In the absence of credible evidence to
establish a relationship between the funds borrowed and specific investments or
specific sources of income from a business or property, I am ruling that the
Appellant has not shown that he was entitled to deduct any of the interest
claimed.
[25] Finally, the
authorization he received to deduct interest in past taxation years does not
automatically entitle him to receive the same treatment for subsequent years.
The law is clear that the Minister is not bound by assessments he may have
issued in the past.
Capital losses
[26] The claim for
capital losses is also related to the loan with the FIA. The loan was made in
the form of a line of credit denominated in U.S. currency. In 1998, when the
Appellant repaid $65,000 to the FIA, the value of the Canadian dollar in U.S. currency was lower than
it was at the time he received the loan. The Appellant calculated his loss
resulting from exchange rate fluctuations to be $36,042.50.
[27] Again, the
Respondent is not challenging the repayment of US$65,000 made by the Appellant
to the FIA in 1998 or the losses sustained by the Appellant at the time of the
transaction, owing to the currency fluctuation. However, the Respondent argues
that the losses do not constitute capital losses because they result from the
discharge of a debt that was not incurred for the purpose of earning income
from a business or property. Alternatively, the Respondent argues that the
calculations made by the Appellant in assessing the losses contain mathematical
errors and that the losses are smaller than the amount claimed.
[28] Losses resulting
from exchange rate fluctuations are covered at subsection 39(2) of the Act, as
follows:
(2) Notwithstanding subsection 39(1), where, by virtue
of any fluctuation after 1971 in the value of the currency or currencies of one
or more countries other than Canada relative to Canadian currency, a taxpayer
has made a gain or sustained a loss in a taxation year, the following rules
apply:
(a) the amount, if any, by which
(i) the total of all such gains made by the taxpayer
in the year (to the extent of the amounts thereof that would not, if section 3 were
read in the manner described in paragraph (1)(a) of this section, be
included in computing the taxpayer's income for the year or any other taxation
year)
exceeds
(ii) the total of all such losses sustained by the
taxpayer in the year (to the extent of the amounts thereof that would not, if
section 3 were read in the manner described in paragraph (1)(a) of this
section, be deductible in computing the taxpayer's income for the year or any
other taxation year), and
(iii) if the taxpayer is an individual, $200,
shall be deemed to be a capital gain of the taxpayer
for the year from the disposition of currency of a country other than Canada,
the amount of which capital gain is the amount determined under this paragraph;
and
(b) the amount, if any, by which
(i) the total determined under subparagraph 39(2)(a)(ii),
exceeds
(ii) the total determined under subparagraph 39(2)(a)(i),
and
(iii) if the taxpayer is an individual, $200,
shall be deemed to be a capital loss of the taxpayer
for the year from the disposition of currency of a country other than Canada, the amount of which capital loss is the amount
determined under this paragraph.
[29] Subsection 39(2)
recognizes that the gains or losses resulting from any foreign exchange
transaction constitute capital gains or losses, except for transactions in
respect of income and gains or losses less than $200. Subsection 39(2)
constitutes an exception to the rules normally applicable to the calculation of
capital gains and losses in the application of the provisions of division B,
sub-division C of the Act. Consequently, the
limitation provided for at subparagraph 40(2)(g)(ii) of the Act, which
assumes that any losses resulting from the disposition of a debt that was not
acquired for the purpose of earning income from a business or property are nil,
does not prevent the recognition of capital losses on foreign currency at the
time such a debt is repaid.
[30] The Canada Customs and Revenue Agency recognizes that
the gains and losses resulting from personal transactions on foreign currency
constitute capital gains and losses under subsection 39(2) of the Act.
Interpretation Bulletin IT-95R says the following at paragraph 5:
5. Sundry dispositions of foreign currency
by individuals, such as a conversion of traveller's cheques in foreign funds to
Canadian dollars on return from a vacation, are considered to be on account of
capital. Foreign exchange losses sustained on the repayment of a debt which
was given to acquire a personal-use property are also considered to be capital
losses under subsection 39(2).
(Emphasis mine.)
[31] Consequently,
because the fact that the Appellant sustained losses resulting from foreign
exchange transactions in the repayment made to the FIA in 1998 is not being
challenged, the Appellant is entitled to consider them to be capital losses
under subsection 39(2).
[32] However, the
calculation of losses made by the Appellant contains errors. It is necessary
to adjust the amount of the losses, taking into consideration the specific
exchange rate between the U.S. and the Canadian dollar in effect in 1992, at the time of
the drawdown from the line of credit. The evidence shows that, at that time,
the exchange rate was C$1.239 per U.S. dollar. This was the rate used by the
Appellant’s accountant to calculate the losses in the calculation sheet, yet the figure was not
transcribed properly on the Appellant’s income tax return. The exchange rate
for 1998, as accepted by the parties, was C$1.5545 per U.S. dollar, which
resulted in capital losses for the Appellant totalling $20,472.92, calculated
as follows:
Difference: $20,472.92
[33] The Respondent
raised an additional issue regarding the calculations made by the Appellant
with respect to capital gains and losses for his 1998 taxation year. The Respondent alleges
that the Notice of Reassessment contained an error: only a portion of the
capital loss deduction that was disallowed was added at the time of the
Appellant’s total capital gains calculation for this year. Consequently, the
Appellant was reassessed, because his capital gains for the year at issue totalled
$64,680 rather than $74,768, as would have been the case had the total amount
of the disallowed capital loss deduction been added. Given that I have
concluded that the Appellant is entitled to capital losses of $20,472.92, the
Respondent would like to deduct $10,087 from this amount, which is equivalent
to the error noted above. In other words, the Respondent maintains that,
because of the error, a portion of the capital losses has already been deducted
and that I should add only the difference to the total eligible losses.
[34] The Appeals Officer
was called as a witness. He filed a table containing the
Appellant’s capital gains calculations for the 1998 taxation year. Included in
this table are the amount of the initial assessment, the amounts admitted to
make the reassessment, and the resulting calculation error. The Appeals
Officer’s evidence in this matter was not challenged during cross-examination,
and I admit that, because of the error made in the reassessment, a portion of
the capital losses has already been allowed. Consequently, the amount for net
capital losses to which the Appellant is entitled is $10,385.92 (given the
calculation error made in the reassessment).
Penalties
[35] It is the Respondent’s burden to prove that the Appellant knowingly,
or in circumstances amounting to gross negligence, made a false statement or
omission in his income tax return for the 1998 taxation year.
[36] In this case, I am not satisfied that the Respondent has discharged
this burden.
[37] The Appellant’s
claim for capital losses was allowed in part, and the claim for the deduction
of interest is based on amounts that he has, in fact, paid as interest. There
is no evidence to enable me to conclude that the Appellant was grossly
negligent in claiming these deductions. It appears that the penalties were
imposed because the Appellant refused to provide documents or make
representations to justify his claims at the time of the audit. The auditor
concluded that the claims were not founded and that they constituted false
statements.
[38] The Appellant
explained to the Court that he chose not to provide documents to the auditor,
because he felt that all of the relevant data had been gathered during the
audit of prior years, and he believed that the CCRA still had them in its
possession. He was apparently told that the data provided to the auditor at
the time of the previous audit was not sufficient, and he refused to accept
this reply. The relationship between the Appellant and the auditor deteriorated,
and the Appellant did not provide the auditor with additional documents to
support his claims. However, given the evidence and the documents filed in
Court during the appeal hearing, the Appellant clearly had grounds, to some
extent, for claiming the deductions, and he genuinely believed that he was
entitled to do so. It is not appropriate to impose penalties in these
circumstances.
Conclusion
[39] Consequently, the
appeal is allowed in part, without costs. The reassessment will be referred
back to the Minister to allow the Appellant additional capital losses totalling
$10,385.92 and to cancel the penalties imposed under subsection 163(2).
Signed at Ottawa, Canada, this 30th day of
July 2004.
Paris J.
Translation certified true
on this 26th day of January 2005.
Colette Dupuis-Beaulne, Translator
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