Byram v. R, 99 DTC 5117, [1999] 2 CTC 149 (FCA)

McDonald J.A.:

The issue to be decided in this case is whether a taxpayer can claim an allowable capital loss pursuant to subparagraph 40(2)(g)(ii) of the Income Tax Act (the “Act”) for losses incurred on interest-free loans issued to a corporation for the purpose of earning dividend income.

Facts

At all material times, the Respondent was a resident of Canada for the purposes of the Income Tax Act.

In the early 1970’s, the Respondent left the employ of a major, multinational oil company to start an oilfield consulting, maintenance and construction company, Byram Industrial Services Ltd. (“BISL”). BISL carries on business in Alberta. At all material times, the only shareholders and managers of BISL were the Respondent and members of his immediate family.

In 1979, the Respondent incorporated a company now known as Elkhound Resources Ltd. (“ERL”). ERL was involved in the exploration and development of oil and gas in Alberta. From the time of its incorporation to the end of February 1984, the only shareholders of ERL were the Respondent, his wife and BISL. At the end of February 1984, Ken Byram, one of the Respondent’s sons, became the sole shareholder of ERL.

By 1981, the Respondent held shares in at least five private companies involved in oilfield consulting, maintenance and construction. In response to the announcement of the National Energy Program in 1981, the Respondent decided to diversify his operations and expand into the United States. In March 1981, he incorporated Elkhound Resources Inc. (“USCO”) in Kansas. From March to April 1981, the Respondent and Ken Byram were the only shareholders of USCO. From April 1981 to April 1982, ERL was the sole shareholder of USCO. From April 1982 until trial, the Respondent, his wife and Ken Byram were the only shareholders of USCO. The Respondent has been an officer and director of USCO since its incorporation.

On June I, 1981, USCO acquired oil and gas rights in Kansas (the “Kansas Property”). The purchase of this property was financed entirely by debt owing to the vendor (the “Greers”) and the Royal Bank of Canada (Portland Branch). Following the purchase, USCO was unable to borrow any additional funds. Accordingly, the Respondent made nine interest-free loans to USCO from March 1981 to October 1982, totalling $336,799.15, in order to finance the operations of the company and the development of the Kansas Property. None of these loans were reduced to writing.

Four loans, totalling $115, 417.55, were made while the Respondent was a shareholder of USCO. Five loans, totalling $221,381.60, were made while ERL was the sole shareholder of USCO. On December 28, 1984, the Respondent sold these loans to Avalie Peck, an employee of BISL, for $1.00.

On his 1984 Canadian tax return, the Respondent reported and claimed $168,400 under paragraph 38(b) of the Act as an allowable capital loss in respect of the disposition of the loans. He used $109,463.50 of this loss to completely offset a taxable capital gain claimed in respect of the redemption of shares that year. He also claimed $2,000 of the loss as a deduction against other income in 1984 pursuant to paragraph 111(1 )(b) of the Act. The remainder of the loss was claimed as deductions against other income pursuant to paragraphs 111 (8)(a) and 111 ( 1 )(b) of the Act in the following manner:

(a) $13,481 in 1982;

(b) $2,000 in 1983;

(c) $2,000 in 1985; and

(d) $21,629 in 1986.

By five Notices of Reassessment dated June 28, 1988 (the “Reassessments”), the Minister denied the Respondent’s loss as claimed, including the offset and deductions claimed in respect of his 1982 to 1986 taxation years. The Minister denied the loss on the grounds that it was not in respect of the disposition of a debt or other right to receive an amount that had been acquired by the Respondent for the purposes of earning income from a business or property, within the meaning of subparagraph 40(2)(g)(ii) of the Act. Accordingly, for the purpose of section 3, the Respondent had no allowable capital loss as defined in paragraph 38(b) and no net capital loss for his 1984 taxation year under paragraph 111 (8)(a) or for the calculation of taxable income for his 1982, 1983, 1985 and 1986 taxation years under paragraph 111(1 )(b).

The Respondent objected to the reassessments but they were confirmed on March 30,1989. The Respondent initiated separate proceedings in the Trial Division appealing each Reassessment. The actions were consolidated for trial. The Trial Judge allowed the appeals, set aside the Reassessments and referred the matter back to the Minister. [1] The Crown appeals to this Court.

Analysis

It is not disputed that the Respondent issued interest-free loans to USCO for the purpose of earning income in the form of dividends from the company. The Appellant, the Crown admits that, in a broad sense, the disputed loan was a device for financing the operations of USCO and that the expected return from the loan is through dividend income. The Appellant argues that by allowing the anticipation of increased dividends to satisfy the test under subparagraph 40(2)(g)(ii) the Court has ignored the “separate entities” principle of corporate law, and the “individual unit” and “source” basis of our income tax system. Furthermore, the Appellant submits that the Supreme Court of Canada established, in Bronfman Trust v. /?., [2] that loans must produce an independent income stream for the taxpayer, through interest or fees, before any losses occasioned by such loans are deductible under subparagraph 40(2)(g)(ii). With respect, I cannot agree.

Bronfman dealt with the deductibility of interest under paragraph 20(1 )(c) of the Act. The relevant portions of section 20 read as follows: 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 applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:...

(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...

[emphasis added]

Subparagraph 20(l)(c)(i) allows for the deduction of interest where money is borrowed and then used for the purpose of earning income from business or property. In Bronfman, the Court held that the application of paragraph 20(1 )(c) requires an examination and characterization of both the use of the borrowed money and the purpose behind such use. [3] For a taxpayer to deduct interest under this section, the purpose of borrowing the money must have been to earn income and the borrowed money had to be directly used in an eligible manner to produce this income.

In contrast, subparagraph 40(2)(g)(ii) of the Act provides that any capital loss from the disposition of a debt is deemed to be nil, unless the debt was acquired for the purpose of gaining or producing income from a business or property. The relevant portions of this section read as follows:

40.(2) (g) a taxpayer’s loss, if any, from the disposition of property, to the extent that it is...

(ii) a loss from the disposition of a debt or other right to receive an amount, unless the debt or right, as the case may be, was acquired for the purpose of gaining or producing income from a business or property (other than exempt income) or as consideration for the disposition of capital property to a person with whom the taxpayer was dealing at arm’s length, ...

is nil.

Unlike paragraph 20(1)(c) this section only requires a single stage inquiry, namely what was the purpose for acquiring the debt. The two stage inquiry laid down in Bronfman clearly indicates that there is a distinction between use and purpose. Therefore, while there are some similarities in the general language of paragraph 20(1)(c) and subparagraph 40(2)(g)(ii), it is significant that section 40 does not contain a “source” directed preamble nor does it refer to use as well as purpose. Accordingly, it would be wholly inappropriate to apply the direct/indirect use limitation imposed in Bronfman to this section.

The language of section 40 is clear. The issue is not the use of the debt, but rather the purpose for which it was acquired. While subparagraph 40(2)(g)(ii) requires a linkage between the taxpayer (1.e. the lender) and the income, there is no need for the income to flow directly to the taxpayer from the loan.

Such an approach is also consistent with commercial reality. Frequently, shareholders make such loans on an interest-free basis anticipating dividends to flow from the activities financed by the loan. To adopt the position of the Minister would require that this Court ignore this reality. It would also be contrary to the comments of the Supreme Court of Canada in Stubart Investments Ltd. v. /?.. [4] Commercial reality is to be considered by the Courts in interpreting tax provisions like subparagraph 40(2)(g)(ii) so long as it is consistent with the text and purpose of the provision. [5]

The ultimate purpose of a parent company or a significant shareholder providing a loan to a corporation is, without question, to facilitate the performance of that corporation thereby increasing the potential dividends issued by the company. This purpose is clearly within the scope of both the text and the purpose of subparagraph 40(2)(g)(ii), a section which is directed towards preventing taxpayers from deducting losses that are not incurred for the purpose of earning income from a business or property.

There is a growing body of jurisprudence that considers current corporate reality as being sufficient to demonstrate that the expectation of dividend income justifies a capital loss deduction under subparagraph 40(2)(g)(ii). [6] As articulated above, this approach is consistent with current corporate realities and the purpose of subparagraph 40(2)(g)(ii).

The Crown relies heavily 011 Canada Safeway Ltd. v. Minister of National Revenue J [7] for its assertion that the potential dividend income from a subsidiary is too remote to support the deduction under subparagraph 40(2)(g)(ii). In Mark Resources, Bowman J.T.C.C. made the following relevant comments on this issue:

The error in relying upon Canada Safeway to deny the deductibility of interest on borrowed money used to purchase shares or contribute capital to a corporation is this: the purpose relied on in that case by the appellant was not the earning of dividends. If that were the purpose alleged the deduction was prohibited [by statute]. The purpose alleged was the effect on the appellant’s own business of owning the shares of the subsidiary. It was this purpose that was rejected by the Supreme Court of Canada as being too remote and indirect to bring the deduction within the restrictive wording of paragraph 5(1 )(b).8 [8]

[emphasis added]

Accordingly, it is clear that the Appellant’s reliance on this case is misplaced.

It is equally clear that the anticipation of dividend income cannot be too remote. It is trite law that sections 3 and 4 of the Act, in conjunction with the rules set out in subdivisions (a) through (d) of division B, establish that the income of a taxpayer is to be determined on a source by source basis. Furthermore, the availability of certain deductions under the Act, including subparagraph 40(2)(g)(ii), require that some regard be given to the source of income that is relevant to the deduction. Accordingly, a deduction cannot be so far removed from its corresponding income stream as to render its connection to the anticipated income tenuous at best. This does not preclude a deduction for a capital loss incurred by a taxpayer on an interest-free loan given to a related corporation where it had a legitimate expectation of receiving income through increased dividends resulting from the infusion of capital.

The shareholders of a company are directly linked to that corporation’s future earnings and its payment of dividends. Where a shareholder provides a guarantee or an interest free loan to that company in order to provide capital to that company, a clear nexus exists between the taxpayer and the potential future income. [9] Where a loan is made for the purpose of earning income through the payment of dividends, this connection is sufficient to satisfy the purpose requirement of subparagraph 40(2)(g)(ii).

In situations where the taxpayer does not hold shares in the debtor, but rather is a shareholder of a parent company or other shareholder of the debtor the taxpayer is not entitled to dividend income directly from the debtor. Generally speaking, the burden of demonstrating a sufficient nexus between the taxpayer and the dividend income, in such cases, will be much higher. The determination of whether there is sufficient connection between the taxpayer and the income earning potential of the debtor will be decided on a case by case basis depending on the particular circumstances involved. Conclusion

During those periods when the Respondent was a shareholder in USCO, he was directly linked to its income generating stream. Any dividends, had they been available, could have been declared in a simple and straight-forward manner. Therefore, the Respondent is entitled to a capital loss deduction in respect of the $115, 417.55 in loans made during this period.

From April 1981 to April 1982, the Respondent made loans, totalling more than $200,000, to USCO. During this period, he did not own shares in USCO, but was a shareholder in ERL, the sole shareholder of USCO. Mr. Byram also held shares in BISL, another shareholder of USCO. At all material times, Mr. Byram and his family were the principal shareholders, officers and directors of the companies involved. Each of these companies was involved in diversifying the Respondent’s oil and gas business into the United States.

The trial judge found that the Respondent’s motivation for the loans was consistent regardless of whether he was a direct shareholder of USCO or not. Furthermore, the trial judge seemed to accept the Respondent’s testimony that ERL became the sole shareholder of USCO from 1981-1982 due to US immigration issues, not business concerns. I accept these findings.

While the Respondent would not have received dividend income directly from USCO from 1981-1982, I am satisfied that the connection between the loans and the potential dividend income is sufficient in the circumstances of this case to invoke the exclusionary clause in subparagraph 40(2)(g)(ii).

Disposition

I would dismiss the appeal with costs. I would also refer the matter back to the Minister for reassessment.

Appeal dismissed.