Dockman v. MNR, 90 DTC 1804, [1990] 2 CTC 2229 (TCC)

Brulé, T.C.J.:—This appeal involves the 1984 taxation year in which the Minister by way of reassessment disallowed a deduction for interest expense to the appellant of $5,147.25.

Facts

In 1979, the appellant loaned his brother the sum of $40,000 to help finance a real estate development in Arizona. Under the terms of the loan, the brother and his partner were to repay the appellant the $40,000 advanced plus an additional $40,000 by way of a premium or bonus in respect of the said advance. In order to provide these funds, the appellant's residence was mortgaged.

In August 1982, the appellant loaned his brother an additional $10,000 for which he was to receive a total of $11,000 in repayment. These funds were obtained through a bank loan.

The project in Arizona ran into many difficulties with the result that the property was sold in November 1984 and the two loans were repaid to the appellant, but no premiums or bonuses were received.

In computing his income for 1984, the appellant deducted interest in the amount of $5,147.25 being $4,494.09 in respect of the mortgage obtained for the first loan and $653.16 being interest paid to the bank in respect of the bank loan.

Analysis

The sole issue in this appeal is whether or not the interest paid on the borrowed sums was used for the purpose of gaining or producing income from a business or property within the meaning of paragraph 20(1)(c) of the Income Tax Act.

I will deal firstly with the right to deduct interest on the second loan of $10,000 made in August of 1982. In order to benefit from the deductions, a reasonable expectation of profit must be shown. In the case of this loan, the appellant borrowed funds from the bank at a rate of over 20 per cent. In return for this loan, the appellant was to receive a maximum of $11,000 including principal. Since the interest income portion of the repayment would be lower than the interest expense payable to the bank, the money borrowed was not being used for the purpose of earning income within the meaning of paragraph 20(1)(c) of the Income Tax Act.

An authority for not allowing the interest deduction on this second loan may be found in the case of Phoenix Overseas Operations Ltd. v. M.N.R., [1971] Tax A.B.C. 273 ; 71 D.T.C. 207 wherein the Court held that interest expense incurred by an investment company on money borrowed from the bank and reloaned at a lesser rate after a six-month interest-free period to a fellow member of a consortium was held not deductible.

With respect to the first loan of $40,000 made in 1979, the appellant expected to receive back $80,000. From this had to be deducted payments made by the appellant for the funds and then any remaining profit was to be shared with the appellant's spouse.

The taxpayer contended that the loan of $40,000 in return for a promise of getting back $80,000 constituted an adventure in the nature of trade so as to bring him within the source of income known as "business".

Thorson, P. in the case of M.N.R. v. James A. Taylor, [1956-60] Ex. C.R. 3; [1956] C.T.C. 189; 56 D.T.C. 1125 dealt at length with the authorities speaking of "trade" and "adventure in the nature of trade". In the judgment, reference was made to the term “business” to include any gainful activity. Furthermore, subsection 248(1) of the Income Tax Act also provides that the meaning of “business” includes an “undertaking of any kind whatever". The activity of the taxpayer in the present case could be defined as such an undertaking so as to qualify the source to business. In lending $40,000 with the hope of getting back double the amount, it could be said that the taxpayer was embarking upon a commercial adventure, and the word “undertaking” could be interpreted as being meant to cover this type of commercial adventure which is not in the nature of trade.

In the case of M.N.R. v. Valclair Investment Ltd., [1964] Ex. C.R. 466; [1964] C.T.C. 22; 64 D.T.C. 5014 Kearney, J. said at page 30 (D.T.C. 5018): "the word 'adventure', in my opinion, is akin to 'undertaking'".

While the appellant's position is that this loan was made for the purpose of producing or gaining income one must consider what was said by Pigeon, J. in the Supreme Court of Canada case of M.N.R. v. Henry J. Freud, [1969] S.C.R. 75; [1968] C.T.C. 438; 68 D.T.C. 5279 as a note of caution at page 443 (D.T.C. 5282):

It is, of course, obvious that a loan made by a person who is not in the business of lending money is ordinarily to be considered as an investment. It is only under quite exceptional or unusual circumstances that such an operation should be considered as a speculation.

I do not believe that the facts in the present case can be considered as anything but exceptional or unusual. The source of the borrowed funds is not important as was pointed out in the case of Brian Wilson v. M.N.R., [1988] 2 C.T.C. 2053; 88 D.T.C. 1418 wherein Christie, A.C.J.T.C. said at pages 2054-55 (D.T.C. 1419):

It is perhaps superfluous to add that the fact that repayment of money that is borrowed is secured by a mortgage on the borrower's personal residence does not, of itself, preclude the interest payable on that mortgage being deductible in computing a taxpayer's income under paragraph 20(1)(c). It is the purpose for which the borrowed money is used that determines the deductibility of interest payable thereon, not the manner in which the loan is secured.

If the additional $40,000 had been received, it would have been classed as income. As to the source of the income being considered to be the property in Arizona, this is rejected because the taxpayer had no direct participation in the project by way of any ownership or shares. As to the argument by the Minister's counsel that the appellant's spouse was a one-half owner of any source of income this may be discarded, as evidence showed that only the appellant paid the interest on the borrowed funds, even though the spouse may have shared in any income that may have resulted over and above the $40,000 loan.

While it is accepted that the appellant had a reasonable expectation of profit, where the purpose for which the funds were borrowed no longer exists the interest expense deduction will no longer be available. The Courts have made this quite clear in several cases including Russell I. Emerson v. The Queen, [1986] 1 C.T.C. 422; 86 D.T.C. 6184 and Botkin (W.F.) v. M.N.R., [1989] 2 C.T.C. 2110; 89 D.T.C. 398.

In the present case, the promissory note was still in existence at the time the Arizona property was sold but after that date, there was no possibility that it could be producing income. Any portion of the interest expense that may have been incurred by the taxpayer on the $40,000 loan after the sale of the property is disallowed. Prior to that time such interest expense is allowed in the 1984 taxation year.

The result is that the appeal is allowed and the matter referred back to the Minister for reconsideration and reassessment on the basis that no deduction may be made for interest expense made in 1984 respecting the $10,000 loan while interest expense in the same year respecting the $40,000 loan is deductible under the provisions of paragraph 20(1)(c) of the Act up to the time of the sale of the property.

The appellant is entitled to his costs.

Appeal allowed in part.