Matheson v. The Queen, 74 DTC 6176, [1974] CTC 186 (FCTD)

Mahoney, J:—This action is an appeal against the disallowance by the Minister of National Revenue of the deduction of interest expense in the amounts of $2,337.32 and $2,610.42 incurred by the plaintiff and claimed in his personal income tax returns for the years 1968 and 1969 respectively on the basis that it was not incurred for a purpose contemplated by paragraph 11(1 )(c) of the Income Tax Act, RSC 1952, c 148, as it then stood. The material portions of that paragraph are as follows:

11. (1) . . . the following amounts may be deducted in computing the income of a taxpayer for a taxation year:

(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 . . .

The plaintiff is a barrister and solicitor residing and practising in Edmonton, Alberta. He has been president of Direct Lumber Company Ltd (herein called “Direct”) since 1949 and, during the relevant period, was owner of about 80% of its outstanding shares. Direct is actively engaged in the manufacture and retailing of lumber and building supplies. Prior to 1965 the plaintiff carried on his law practice in space shared with Direct in its leased premises. During 1965, due to the pending expiration of the lease and partial destruction of the premises by fire, it became necessary to seek a new location.

On May 21, 1965 the plaintiff personally entered into an option to acquire suitable premises consisting of land, a building and equipment for which the purchase price was $50,000, including the $2,000 paid for the option. The vendor was a hardware and lumber merchant and the option provided for the sale of his stock in trade at its wholesale cost. The option was exercised and a formal agreement was entered into July 23, 1965 apportioning the purchase price which, including the stock-in-trade, was $63,164.74. The plaintiff was not a party to this agreement. The purchasers were Direct and Allied Building Credits Ltd (herein called “Allied”). An existing mortgage of $14,975.65 was assumed and the balance paid in cash. Title to the property was taken by Direct alone.

There is absolutely no evidence before me as to Allied’s business activities, if any, or as to it being a source of income for the plaintiff, either real or potential. The plaintiff referred to it as “semi-active”. The relevance of its existence to the issue herein is limited to its appearance as a party to the agreement of July 23.

The plaintiff had taken a personal loan from a chartered bank for the $2,000 option price and borrowed a further $48,000 personally from another chartered bank to close the deal. The $2,000 loan, as Allied, disappears from the scene in so far as the evidence before me goes.

Until the end of 1966 the $48,000 loan was treated by the plaintiff and Direct as though it was an obligation of Direct rather than the plaintiff. Direct dealt with the bank, paid the interest and, by December 31, 1966, had reduced the principal balance to $32,000. At this time, the chartered bank called the loan and the plaintiff, again personally, arranged a $32,000 loan from the Treasurer of Alberta through an Alberta Treasury Branch. It is the interest on this loan, paid during 1968 and 1969, that is in issue.

Instead of treating the loan as its own and making the payments to the Treasury Branch, Direct set up a liability of $32,000 to the Plaintiff. The account is entitled “J.A. Matheson Legal”. The ledger sheet for the period January 3, 1967, when it opened with a credit balance of $32,000, to March 11, 1970 is in evidence. During 1967, a year in which Direct reported legal expenses of $181.34, there were over 130 entries in the account with debits totalling $40,028.17, additional credits totalling $50,125.57 and a year end credit balance of $42,097.40. During 1968, with legal expenses of $152.30, there were over 100 entries in the account with debits totalling $42,613.82, credits $49,149.82 and a year end credit balance of $48,633.40. During 1969, with legal expenses of $25.63, some 75 entries reflected debits of $22,776.70, credits of $39,064.55 and the year end credit balance was $64,921.25.

On or about the last day of every month from January 1967 through February 1968 there is a debit entry of $1,145 and on or about the last day of every month from March 1968 through December 1969 there is a debit entry of $845. Most of the other entries, both debit and credit, although random in timing, are for multiples of $50, $100 or $1,000. The plaintiff was not particularly forthcoming in his testimony about particular entries in this account. Having in mind the fact that Direct, whose fiscal year is the calendar year, discloses legal expenses of $181.34 in 1967, $152.30 in 1968 and $25.63 in 1969 in the statements appended to its corporate tax returns, which are in evidence, I must conclude that the account was inappropriately captioned and that it was a general account covering most, if not all, of the plaintiff’s transactions with Direct.

It is possible that there were other accounts between the plaintiff and Direct during this time. Details of them are not in evidence and the plaintiff said that he believed that this was the only active account during the period. That being so, it is clear that the plaintiff’s advances to Direct exceeded his withdrawals from it in each of the years 1967, 1968 and 1969.

The plaintiff denies specifically that any of the entries in this account represent payments to him that were passed through to the Treasury Branch on account of his debt to it, either principal, interest or mixed. Rather, during the period, the Treasury Branch simply debited the plaintiff’s personal account with a $500 monthly principal payment plus the month’s accrued interest.

Thus in addition to a net increase of almost $33,000 in his advances to Direct over the 3-year period, the plaintiff personally paid the interest on and reduced the principal of the loan he had made for its benefit. His disappointment at the disallowance of his deduction of the interest expenses is particularly understandable in the light of the practical effect of the arrangement that had prevailed during 1965 and 1966 when Direct, although not a party to the plaintiff’s agreement with the bank, had paid and been allowed to deduct the interest on his debt. The plaintiff does, however, acknowledge that there was no arrangement with Direct, prior to the end of 1969, whereby interest was payable to him on account of this loan and, further, that none was paid.

Direct paid the plaintiff a salary or wages of $600 and he received additional taxable benefits of $1,000 from it in 1968. No such income was reported in 1969. Direct paid no dividends in either year.

The plaintiff appeared, in his argument, to recognize the untena- bility of his position to the extent that the money borrowed was used by Direct to earn income from its business rather than by the plaintiff to earn income from his own business.* [1] He argued that the provision of premises for Direct to operate from had been by no means the sole purpose of the $48,000 loan when it was originally made in 1965 nor of the replacement loan made in 1967.

It was also to provide the plaintiff with a separate legal office from which he could also conduct an investment business. If that were indeed a purpose of the loan, the propriety of Direct paying all of the interest thereon up to the end of 1966 may be questioned, as may the arrangement which he acknowledges having made with Direct for the payment of interest from 1970 on. In any event the provision of an office for the conduct of the plaintiff’s professional and investment business can scarcely have called for the acquisition of as much or of the type of property as was actually acquired. The plaintiff did not, in evidence or argument, attempt to apportion the loan between his own and Direct’s business and I have, therefore, no basis on which to determine how much, if any, of the interest was paid by the plaintiff in respect of money borrowed to earn income from his own business. If the plaintiff wished seriously to pursue this argument, the onus was on him to support it with evidence.

An office was also provided for Allied. The position of the plaintiff in claiming the interest expense personally for this reason is, of course, precisely the same as his position vis-a-vis Direct and its business.

Another argument advanced is that the interest expense should be allowed the plaintiff because, as a result of the loan, his investment in Direct has increased in value. This argument ignores the distinction between income and capital appreciation and cannot be sustained.

The plaintiff further argues that, instead of making the loan, he could have liquidated other, income-producing, assets but that he chose instead to borrow from the bank and pay the interest in order to protect and increase his other investments. While that argument is, indeed, ingenious, I must deal with what, in fact, happened rather than what might have happened.

The evidence leaves no doubt whatever that the original $48,000 loan was made to provide the funds to pay for the land, building, equipment and stock-in-trade acquired in July 1965 and for no other purpose. Regardless of any other rights that may have existed prior to closing, the sole beneficial and legal ownership of the assets acquired was vested in Direct upon closing. There is equally no doubt that the $32,000 loan was made to refinance the balance of the Original loan outstanding at the end of 1966 and that the purpose for which it was made cannot, on the evidence, be distinguished from the purpose for which the original loan was made. That purpose was to acquire assets to permit Direct to earn income from its business. Direct’s business is not the plaintiff’s business: whether as a shareholder, officer, director, tenant or professional adviser, the plaintiff cannot claim Direct’s income as his own.

While I may sympathize with the plaintiff inasmuch as it would likely have been possible to arrange matters in a way that could have permitted Direct, if not himself, to claim the interest expense, I must deal with the situation that in fact existed during the taxation years in question. Neither am I free to speculate on why matters were ar- ranged as they were. The interest expense claimed by the plaintiff and disallowed by the Minister was not paid or incurred in respect of borrowed money used to earn income from the plaintiff’s business or property and the reassessments are accordingly sustained.

The action is dismissed with costs.