Date: 19980828
Docket: 96-2868-IT-I
BETWEEN:
JOSEPH H. KRONSTAL,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for Judgment
O'Connor, J.T.C.C.
[1] These appeals were heard at Yellowknife, Northwest
Territories on August 5, 1998.
[2] The only witness heard was the Appellant himself.
Issues
[3] The issues are:
(a) whether the Appellant was entitled to deduct interest
expenses in the amount of $1,660.73, $1,456.29 and $1,254.03 for
the 1992, 1993 and 1994 taxation years respectively in respect of
monies borrowed on the Appellant's personal line of credit
and advanced to two corporations of which the Appellant was a
shareholder;
(b) whether the Appellant was entitled to Allowable Business
Investment Losses ("ABIL(s)") in the amounts of $4,391,
$9,300 and $16,548.93 in the 1992, 1993, and 1994 taxation years
in respect of monies advanced to the said two corporations.
Facts
[4] I find the principal facts to be as follows:
1. The Appellant, prior to 1987, was an advisor to the
Northwest Territories Development Association and in that role
advanced as one of his concerns that it would be beneficial to
the community if a local dairy operation could be established. To
that end he involved 48 investors. An 80 cow operation was
contemplated. After much investment of time and money this first
venture, carried on through a corporation called Agriborealis
Ltd. ("Agriborealis"), failed and went into
receivership in 1987 mainly because of difficulties in complying
with dairy operation regulations based upon standards used in
Alberta. In 1988 the Town of Yellowknife
("Yellowknife") purchased from the Trustee in
Bankruptcy of Agriborealis the land which had been set aside for
the dairy operation.
2. Around the same time the Appellant was hired by Yellowknife
in its financial department. He was still interested in a dairy
project. He arranged for the incorporation of Tuaro Dairy
Corporation Ltd. ("Tuaro") in 1990 and West Arctic Six
Ltd. ("West") in 1991. Both are Canadian controlled
private corporations and qualify as small business corporations.
West was originally planned as a dairy equipment rental
operation. It purchased the equipment and leased same to Tuaro. A
lease was executed and two lease payments were made prior to the
events described below.
3. The Appellant was a substantial (but not majority)
shareholder in Tuaro and West and at arm's length with both
corporations. Several other investors were also involved in
both.
4. At least three attempts were made to obtain financing for
the dairy operation. These did not succeed and it was only in
1995 that The Canadian Imperial Bank of Commerce
("CIBC") agreed to finance, subject to certain
conditions including security on the dairy equipment and Tuaro
being free of debt. Thus, the lease between Tuaro and West of the
dairy equipment was terminated and West conveyed the equipment to
Tuaro in exchange for shares in Tuaro. The operation was to be
carried on on the property which Yellowknife had leased to Tuaro
for an initial five-year term with rights to renew and rights to
purchase in favour of Tuaro.
5. The operation took time to get going, owing to various
problems including delays in product testing and ferry problems
bringing in cows. The operation finally commenced in May, 1996.
The June 12, 1996 edition of the
"Yellowknifer" contained an article pronouncing that
the "first batch of locally produced milk in years is now on
the shelves" and confirmed that Tuaro began its operation
from its plant approximately two weeks prior to June 12. This
article went on to describe the operation and the new efficient
equipment which had been installed.
[5] Before describing the investments made by the Appellant in
the corporations, it should be noted that, for various reasons,
Tuaro went into receivership in March of 1998.
[6] The Appellant invested in the corporations, both by
acquiring shares and advancing loans. In these appeals the
interest expenses and the ABILs claimed relate only to the monies
advanced by way of loans. Complete details of the interest
expenses and ABILs claimed are provided in Schedules 1, 2 and 3
of the Reply to the Notice of Appeal. In summary, the Appellant
made the following loans to Tuaro and West, namely: $5,855 in
1992 (ABIL $5,855 x 3/4 = $4,391); $12,400 in 1993
(ABIL $12,400 x 3/4 = $9,300); and $37,065.24 in 1994 (ABIL
$37,065.24 x 3/4 = $27,798.93). The Minister disallowed the ABILs
claimed in 1992 and 1993 and, in 1994, allowed $15,000 of the
$37,065.24 claimed. Thus, with respect to 1994 the ABIL in
dispute is $16,548.93 ($27,798.93 - 3/4 of $15,000 or $11,250).
The $15,000 allowed related to a settlement regarding
Agriborealis which is not of concern in this appeal.
[7] The Appellant testified he never expected to be repaid the
advances. They were made to start up the corporations with the
expectation that in the future the corporations would be
profitable and pay dividends.
[8] The total interest expenses claimed by the Appellant were
as follows:
1992 $3,276.29
1993 $2,419.44
1994 $3,172.74
Of these amounts the Minister allowed the following,
namely
1992 $1,615.56
1993 $963.15
1994 $1,918.71
thereby leaving in dispute the following amounts:
1992 $1,660.73
1993 $1,456.29
1994 $1,254.03
In a letter accompanying the reassessment the Minister stated
that the reason for disallowing the interest expenses in dispute
was "the purpose of the funds advanced by the CIBC Personal
Line of Credit was not determined by the supporting documentation
submitted". The Appellant testified that the monies advanced
to him on his personal line of credit were in turn advanced to
the corporations at the same interest rate that the CIBC charged
the Appellant.
Submissions of the Appellant
(Hereafter, all provisions mentioned are references to the
Income Tax Act ("Act")).
[9] The Appellant submits with respect to the interest
expenses that all of the interest he claimed, including the
amounts in dispute, were in respect of advances made to the
corporations for the purposes of earning income from a business
or property. The Minister has accepted certain amounts claimed as
interest but has disallowed the portions thereof which relate to
"personal line of credit". The Appellant submits that
his testimony is clear that, notwithstanding reference to the
personal line of credit, the monies he borrowed in that account
were advanced to the corporations in the same way as the other
amounts advanced the interest on which the Minister has allowed.
The Appellant refers to Revenue Canada's Interpretation
Bulletin IT-445 which he submits supports his claim for the
interest expense deductions. Admittedly, the Appellant borrowed
monies from CIBC at a certain interest rate and advanced those
monies to the corporations at the same interest rate. This,
however, in the Appellant's view, does not negate the fact
that the monies were advanced for the purpose of earning income
from a business or property.
[10] With respect to the ABILs, the Appellant refers to
Revenue Canada's Interpretation Bulletin IT-484R2 in support
of his claim. He refers to his testimony that he realized he
never would recover the amounts advanced. In his 1992, 1993 and
1994 returns he declared the advances as bad debts and claimed
the ABILs related thereto. Further he advanced the monies to get
the businesses going and as start up, not expecting to be repaid
those monies, but once the corporations were operating profitably
they would provide an income stream to him by way of
dividends.
Submissions of the Respondent
[11] With respect to the interest expenses the Respondent
submits that the Appellant has not proven that he acquired a debt
for the purposes of gaining or producing income from a business
or property. Counsel for the Respondent points out that the
interest charged by the Appellant on the loans to the
corporations was the same as the interest that he had to pay to
the CIBC and deduces from that that the monies were not loaned
for the purposes of gaining or producing income from a business
or property.
[12] With respect to the ABILs, counsel contends that the
Appellant has not proven that he incurred the losses within the
meaning of paragraph 39(1)(c) of the Act. More
specifically, that the Appellant did not incur a capital loss
from a disposition to which subsection 50(1) of the Act
applies of a debt because the Appellant did not make a
disposition of the debt. Counsel concludes that the Appellant is
not entitled to the ABILs claimed because he does not meet the
conditions established in subsection 50(1),
paragraph 39(1)(c) and 40(2)(g) of the
Act.
Analysis and Decision
[13] The relevant provisions of the Act, so far as
material, are 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 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) 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 ...
39 (1) For the purposes of this Act,
...
(c) a taxpayer's business investment loss for a
taxation year from the disposition of any property is the amount,
if any, by which the taxpayer's capital loss for the year
from a disposition after 1977
(i) to which subsection 50(1) applies, ...
of any property that is
(iii) a share of the capital stock of a small business
corporation, or
(iv) a debt owing to the taxpayer by a Canadian-controlled
private corporation ... that is
(A) a small business corporation, ...
exceeds the total of ...
40 (2) Notwithstanding subsection (1),
...
(g) a taxpayer's loss, if any, from the disposition
of a 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 by the taxpayer 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; ...
50 (1) For the purposes of this subdivision, where
(a) a debt owing to a taxpayer at the end of a taxation
year ... is established by the taxpayer to have become a bad debt
in the year, or
(b) a share ...
the taxpayer shall be deemed to have disposed of the debt or
the share, as the case may be, at the end of the year for
proceeds equal to nil and to have reacquired it immediately
thereafter at a cost equal to nil.
[14] The following extracts from the relevant Interpretation
Bulletins are helpful.
IT-445
General Position
3. Interest expense on money borrowed to be loaned at a
reasonable rate of interest, or to honour a guarantee which had
been given for adequate consideration, is generally deductible.
However, interest expense incurred on borrowed money is generally
not deductible in whole or in part when that money
(a) is loaned interest-free or at less than a reasonable rate
of interest. ...
6. A loan will not be considered to be made at a reasonable
rate of interest where a shareholder borrows money at interest
and loans that money to a corporation of which he is a
shareholder, or to its subsidiary controlled corporation
(subsidiary), at a lesser rate of interest than that at which the
shareholder borrows the money.
Exception to the General Position
7. Notwithstanding the comments in 3, 5 and 6 above, the
Department will generally permit a deduction for the full
interest expense incurred when a taxpayer borrows money at
interest to be loaned to a Canadian corporation of which he is a
shareholder ... at less than a reasonable rate of interest, (or
at no interest), if the following conditions are met:
(a) the proceeds of the loan are used by that corporation in
its own operations to produce income from business or property
which will be subject to Part I tax in Canada, or ...
(b) the corporation has made every effort to borrow the
necessary funds through the usual commercial money markets but
cannot obtain financing, without the guarantee of the
shareholder, at interest rates at which the shareholder could
borrow, and
(c) the loan from the shareholder to the corporation at less
than a reasonable rate of interest (or at no interest) does not
result in any undue tax advantage being conferred on either the
shareholder or the corporation. ...
...
IT-239R2
5. Similarly, money which had been loaned at a reasonable rate
of interest generally constitutes a debt acquired for the purpose
of gaining or producing income, and any capital loss which arises
because it has become uncollectible is generally not deemed to be
nil by virtue of subparagraph 40(2)(g)(ii). It is the
Department's view that money has not been loaned at a
reasonable rate of interest where a taxpayer borrows money at
interest and loans that money to a corporation of which he is a
shareholder, or to its subsidiary controlled corporation
("subsidiary"), at a lesser rate of interest than that
at which the taxpayer borrows the money.
...
IT-484R2
Summary
A business investment loss is basically a capital loss from a
disposition to which subsection 50(1) applies, or to an arm's
length person, of shares or debt of a small business corporation.
Three-quarters of this loss is an allowable business investment
loss.
Unlike ordinary allowable capital losses, an allowable
business investment loss for a taxation year may be deducted from
all sources of income for that year. Generally, an allowable
business investment loss that cannot be deducted in the year it
arises is treated as a non-capital loss which may be carried back
three years and forward seven years to be deducted in calculating
taxable income of such other years. Any such loss that is not
deducted by the end of the seven-year carry-forward period is
then treated as a net capital loss so that it can be carried
forward indefinitely to be deducted against taxable capital
gains.
Ordinary allowable capital losses for a taxation year may be
deducted only from taxable capital gains realized in the year. If
the allowable capital losses exceed the taxable capital gains,
the difference is a net capital loss which may be carried back
three years and forward indefinitely to be deducted only against
taxable capital gains.
The purpose of the rules relating to the business investment
loss is to encourage investment in small business corporations by
giving such losses more generous tax treatment than that
available for ordinary capital losses.
This bulletin discusses the various provisions of the Act
relevant to determining what constitutes a taxpayer's
allowable business investment loss for a taxation year and the
deductibility of such a loss.
Discussion and Interpretation
1. An "allowable business investment loss" is
defined in paragraph 38(c) as 3/4 of a "business
investment loss" defined in paragraph 39(1)(c). To
qualify as a business investment loss, an amount must first be a
capital loss. Thus when a transaction does not give rise to a
capital loss, or when a capital loss is deemed to be nil (e.g.,
under paragraph 40(2)(g)), no business investment loss can
result.
Although a business investment loss for a year must first
qualify as a capital loss, a taxpayer does not have the option of
treating it as a capital loss for the year rather than a business
investment loss.
...
3. A taxpayer's business investment loss may arise from
the disposition of:
(a) a share of a corporation that is a small business
corporation, or
(b) a debt owing to the taxpayer (except as discussed in
paragraph 5 below) by a Canadian-controlled private
corporation.
For a loss on the disposition of such property to qualify as a
business investment loss, the disposition must be to an arm's
length person or be deemed to have occurred under
subsection 50(1) (see paragraph 6 below). ...
...
6. Subsection 50(1) deems a taxpayer to have disposed of a
debt or a share of a corporation at the end of a taxation year
for nil proceeds and to have reaquired it immediately thereafter
at a cost of nil if:
in the case of a debt (other than a debt from the sale of
personal use property), the debt is owing to the taxpayer at the
end of the taxation year and it is established by the taxpayer to
have become a bad debt in the year; and ...
[15] As to the amounts of interest disallowed the Minister has
only disallowed the portions of the interest claimed which relate
to the personal line of credit. The Appellant testified (the
Appellant's credibility is accepted without reserve) that
although the amounts were borrowed from CIBC on his personal line
of credit, the total of those amounts nevertheless went into the
corporations and the amounts advanced were for the purpose of
earning income from a business or property. I do not believe that
his interest costs of borrowing the money from CIBC being equal
to the interest cost he was charging to the corporations negates
the Appellant's intention to earn income as a result of the
advances. Reference is made to the Interpretation Bulletins
(ITBs) referred to above. The rate charged to the corporations
was a reasonable rate and the ITBs support the Appellant's
position. In conclusion, I have no doubt that the amounts
advanced to the corporations (although representing monies
advanced by CIBC on the Appellant's personal line of credit)
were advanced to the corporations for purposes of earning income
and were properly deductible.
[16] As to the ABILs claimed, the Appellant did not convey the
debts to a third party for nil or minimal consideration nor did
he forgive the debt or exhaust all legal remedies to get paid.
The Appellant's case would have been stronger had any of
those events occurred. Nevertheless, I am satisfied that the
Appellant, as required by subsection 50(1), has
established the debts to have become bad in the years in
question. In my opinion there has been a deemed disposition of
the debt as the Appellant's uncontroverted testimony
establishes that the debts were bad. He knew he could not recover
the advances. The Appellant treated them as bad and so filed his
income tax returns. His testimony was that he never expected the
money back (after the initial attempts at financing failed).
Consequently the debts have been proven to be bad. As the
Appellant explained, he advanced these monies to keep the
businesses alive expecting future income flows through dividends.
The monies advanced were for start-up costs and to create and
keep the business going to a point where it could earn a profit.
As ITB 484R2 states "The purpose of the rules relating to
the business investment loss is to encourage investment in small
business corporations by giving such losses more generous tax
treatment than that available for ordinary capital losses".
If that is the purpose, the Appellant's situation cries out
for the application of the rules.
[17] Further, I do not believe that paragraph
40(2)(g)(ii) is applicable to render the loss nil. In my
opinion, the Appellant has proved that the advances were made for
the purpose of earning income from a business or property; and
further there was no non-arm's length element involved.
[18] I believe the following statement of Rip, J. in
Business Art Inc. v. M.N.R., 86 DTC 1842, at 1848, applies
a fortiori to these appeals:
However, even if no interest was chargeable I do not believe
that would be fatal to the appellant's alternate submission.
The fact that there may have been no interest attached to the
debts in question is not relevant in deciding whether they were
acquired for the purpose of gaining or producing income. See The
Queen v. Lalande and Watelle, 84 DTC 6159 at page 6164. It
is not uncommon for a shareholder to lend money without interest
and without security to the corporation since he anticipates that
the loans will assist the corporation to earn income and to pay
him income by way of dividends; the loan is made for the purpose
of earning income from a property. Although the shareholder is a
creditor of the corporation when he advances money to the
corporation the shareholder does not see his advance of money to
the corporation and his subscription for shares of the
corporation as separate investments in two watertight
compartments; rather he sees his money entering two compartments
which open up into a single compartment for the use of the
corporation. Purchasing shares and advancing money to a
corporation are two ways of making an investment in the
corporation. This is a sensible interpretation.
Similarly a shareholder of a corporation who may have
incorporated a corporation for the purpose of acquiring product
at a low cost and so reduce its own costs may advance money
without interest to the corporation to enable the corporation to
operate as intended; in this example even if the shareholder is
not making loans for the purpose of producing income from its
business, by having reduced costs, the loan is being made to earn
income form property, that is, to receive dividends on the shares
it owns in the corporation. It is not unusual for a person to
invest in a corporation by subscribing for share capital and
lending money without interest; as far as he is concerned the
shares and his loans constitute a single investment and if later
on, he is called on to advance further funds without interest he
is only increasing his investment. I cannot subscribe to the
theory that in such an example the non-interest bearing loans
were not incurred for the purpose of earning income from
property; if the loans were not advanced the corporation may have
become bankrupt and the shares may have become worthless. Clearly
the loans were made to earn income from property, that is, to
place the corporation in a position where it will be successful
and pay dividends.
[18] I note that no claim for loss on the investment of monies
to acquire shares of the corporations has been claimed by
the Appellant. His claims in this regard relate only to the
loans that went bad. One may deduce from that that the
Appellant did not consider he had a loss on the shares as he
expected the corporations to operate and generate revenues but
that he had a loss on the loans knowing he could not recover
them.
[19] Perhaps these appeals would not have proceeded to trial
had the Minister realized prior to trial that certain of the key
assumptions in the Reply would be refuted. I refer specifically
to the assumptions that the Appellant was a majority shareholder
of Tuaro, was not dealing at arm's length with Tuaro or West
and that Tuaro and West did not commence operations.
[19] By way of obiter, I add that, if as the Appellant
testified, Tuaro went into receivership in 1998 and the appellant
still owned shares at that time, there would presumably be a loss
on the shares in 1998. Moreover, if I am wrong in concluding that
losses on the loans were incurred in 1992, 1993 and 1994, such
losses presumably would clearly chrystallize in 1998 enabling the
Appellant to claim them in that year and/or to carry them back
three years or forward as provided in section 111 of the
Act.
[20] In conclusion, for all of the above reasons, the appeals
are allowed and the matter is referred back to the Minister of
National Revenue for reconsideration and reassessment on the
basis that the Appellant was entitled to deduct the interest
expenses and ABILs claimed in the 1992, 1993 and 1994 years.
Signed at Ottawa, Canada this 28th day of August 1998.
"T.P. O'Connor"
J.T.C.C.
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