Citation: 2010TCC306
Date: 20100604
Docket: 2009-2798(IT)I
BETWEEN:
BRUNA BERNACCHI,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Sheridan, J.
[1] The Appellant,
Bruna Bernacchi, is appealing the reassessments of her 2005, 2006 and 2007
taxation years. At the hearing, the Appellant abandoned her claim for an
allowable business investment loss; the only issue in dispute is her entitlement
to an interest expense deduction for amounts advanced from a line of credit to
Maple Gate Bakeries Inc. (the “Bakery”), a business in which her former spouse
held shares.
[2] In
reassessing the Appellant’s 2005, 2006 and 2007 taxation years, the Minister
relied on the assumptions of fact set out in paragraph 15 of the Reply to the
Notice of Appeal:
a)
in filing her return of income for the 2006
taxation year, the appellant claimed a deduction for an allowable business
investment loss (“ABIL”) in the amount of $77,500;
b)
the ABIL claimed was in respect of investments
in a corporation, Maple Gate Bakeries Inc. (“Maple Gate”) and was calculated as
follows:
|
share purchase
amount financed from joint line of credit
|
$
52,500
|
|
share
purchases financed by promissory notes
|
20,000
|
|
interest paid
to a third party from whom shares were bought with a promissory note
|
5,000
|
|
total claimed
|
$
77,500
|
c)
in preparing her returns of income, the
appellant claimed deductions in the amounts of $3,001.29, $5,742.90 and
$8,406.37 as interest expenses incurred in the 2005, 2006 and 2007 taxation
years, respectively;
d)
the interest expenses claimed in each of the years
under appeal were in respect of investments in Maple Gate made by the
appellant’s former spouse in the form of share purchases;
e)
Maple Gate went bankrupt on December 1, 2006;
f)
the appellant was never a shareholder of Maple
Gate;
g)
the appellant’s former spouse was a shareholder
of Maple Gate;
h)
the appellant’s former spouse used a combination
of interest-bearing promissory notes and funds from a secured line of credit
held jointly with the appellant to purchase his shares of Maple Gate from a
third party;
i)
the appellant’s former spouse acquired his
shares in Maple Gate prior to the years under appeal;
j)
the appellant and her former spouse became
separated in 2004 and signed a formal separation agreement in September 2005;
k)
at the time of the separation, the matrimonial
home had two mortgages, one of which being the secured line of credit, a part
of which had been used to finance the purchase of the Maple Gate shares owned
by the appellant’s former spouse;
l)
as part of the division of marital assets and in
accordance with the separation agreement:
i)
the appellant assumed responsibility for the
mortgage and the secured line of credit;
ii)
the appellant’s former spouse relinquished any
claim on the matrimonial home;
iii)
the appellant’s former spouse assumed
responsibility for repayment of an outstanding promissory note to a third party
from whom his shares were purchased;
iv)
the appellant waived any interest she had or
might have in her former spouse’s interest in Maple Gate; and
v)
the appellant was released from any obligation
to pay spousal support to her former spouse;
m)
the interest expenses claimed as deductions by
the appellant were primarily incurred in respect of the secured line of credit.
[3] The Minister disallowed the Appellant’s
claim for an interest expense deduction under subparagraph 20(1)(c)(i)
of the Income Tax Act because she “… did not acquire the debt for the
purpose of gaining or producing income from a business or a property, but
rather as part of her separation agreement with her former spouse”.
[4] With the exception of assumption 15(e), the
Appellant does not dispute the facts assumed by the Minister but asserts they
are incomplete and/or ignore the reality of the situation. She admitted,
however, the facts set out in assumptions 15(d), (h) and (k):
(d) the interest expenses claimed in each of
the years under appeal were in respect of investments in Maple Gate made by the
appellant’s former spouse in the form of share purchases;
…
(h) the appellant’s former spouse used a
combination of interest-bearing promissory notes and funds from a secured line
of credit held jointly with the appellant to purchase his shares of Maple Gate
from a third party;
…
(k) at the time of the separation, the
matrimonial home had two mortgages, one of which being the secured line of
credit, a part of which had been used to finance the purchase of the Maple Gate
shares owned by the appellant’s former spouse;
[5] While acknowledging that the joint line of
credit had been used to purchase her former spouse’s shares in the Bakery and
that the legal documents governing the acquisition of the business were in his
name only, the Appellant testified that it was her money that kept the failing
Bakery afloat: she had full-time employment outside the Bakery and her earnings
were put into the business; she also invested sweat equity in the Bakery
selling cakes, paying suppliers, doing the books and managing its staffing
needs. Further, the matrimonial home was in the Appellant’s name only and was
used to secure the line of credit that financed her former spouse’s purchase of
the Bakery shares. It was also for that reason that the landlord of the Bakery
premises refused to agree to the lease unless the Appellant signed as a guarantor.
[6] Adding insult to injury, at a certain
point, her former spouse’s enthusiasm for the Bakery was diverted to other
pursuits, leaving her to carry on as best she could given all of her other
responsibilities. In these circumstances, the Appellant’s position is that she
ought to be entitled to deduct the interest paid on the joint line of credit.
[7] I must say I found the Appellant’s story a
compelling one. If I were able to decide this case on moral or equitable
grounds, I would have no hesitation in allowing the appeals. However, the
correctness of the Minister’s reassessments must be determined under subparagraph
20(1)(c)(i) of the Income Tax Act:
20(1) Deductions permitted in computing income from business or
property – Notwithstanding paragraphs 18(1)(a), (b)
and (h), in computing a taxpayer’s income for a taxation year from a business …
, 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 … pursuant to a
legal obligation to pay interest on
(i) borrowed money used for the purpose of earning income from a
business …
[8] Counsel for the
Respondent referred the Court to Bronfman Trust v. R. in which the Supreme
Court of Canada held that an interest expense deduction under subparagraph
20(1)(c)(i) is available only where the taxpayer can establish a link between the interest paid
on the borrowed money and an income-earning purpose. This approach was later adopted
by the Court in Shell Canada Ltd. v. R. and reaffirmed in Singleton v. R. in which it was held that “… the inquiry
must be centered on the use to which the taxpayer put the borrowed
funds” [Emphasis added.]. More recently, this
test was applied by the Federal Court of Appeal in Scragg v. R. and restated by
Noël, J.A. as: “A taxpayer cannot deduct interest on borrowed money unless the
money is actually used to produce income.”
[9] This is the hurdle faced
by the Appellant in the present case. She explained how she came to take on
sole responsibility for the joint line of credit:
THE WITNESS: Basically, what happened was that in 2005,
when we legally separated, I assumed the line of credit for the Maple Gate
Bakery. It also released me from any further expenses of the Maple Gate Bakery.
He continued, and I didn't have anything to do with it. This is how we
separated.
MR.
MITONIDES:
Q. Up
until this Agreement to waive your interest in the company, what expenses were
you responsible for?
A. What
was the question, I am sorry?
Q. Up
to this point when you waived your interest in Maple Gate Bakery, what expenses
were you responsible for?
A. Up
until before the Separation Agreement? Before the Separation Agreement I was
responsible for making payments on the credit line. Up until the Separation
Agreement I made sure, as much as possible, that everything was working the way
it should be.
[10] In support of her testimony, the Appellant
put in evidence a letter from the lawyer who represented her in the
matrimonial dispute. He summarized the nature of their agreement as follows:
…
I wish to confirm that after review of the Separation Agreement and
the file, I wish to advise you of the following:
1. In the Separation Agreement, your husband
fully and completely waived any right for spousal support against you now or in
the future regardless of his health or financial circumstances.
2. Your husband transferred his interest in
the matrimonial home to you completely.
3. In consideration of him providing you with
all the equity in the matrimonial home and further, of him waiving and
releasing your legal obligation to pay spousal support to him, you agreed to be
responsible for the payment of the mortgage and release him from that along
with being responsible for the payment of the joint line of credit which was
utilized for business purposes.
4. I wish to confirm that at the time of the
drafting, negotiations, and execution of the Separation Agreement, you were
concerned with respect to your husband’s financial viability and if the bakery
did fail or his income decreased drastically, you did not want to be
responsible to pay him spousal support which would be your legal obligation to
do so pursuant to the provisions of the Divorce Act and the Family Law Act of
Ontario.
Accordingly, from my review of the file and the Separation
Agreement, you did accept responsibility of the mortgage on the matrimonial
home and the joint line of credit which was utilized for the business, in order
to extinguish any legal obligation that you may have to your husband for
spousal support.
[11] Although the
Appellant spoke above of being “responsible” for the Bakery expenses, she took
on that obligation voluntarily in the best interest of what she considered a
family business operation. She ought not to be faulted for that. But it is not sufficient for the purposes of subparagraph
20(1)(c)(i). To qualify for a deduction under that provision, the
Appellant must also show that she used the money borrowed from the line
of credit to finance a business that would generate income for her. While
she hoped, one day, to reap some benefit from the time and money she had ploughed
into the Bakery, because of the way the business was structured, only her
former spouse stood to earn income from it. She had no legal status as either a
shareholder or investor in the Bakery: she had no right to earn dividend
income; nor was there any evidence of an agreement between her and the company
and/or her former spouse pursuant to which she could earn income on the amounts
she had contributed to his share purchase or to keep the business going.
[12] The Appellant’s agent, Mr. Mitonides,
argued because the matrimonial home was in her name only and had been used to
secure the joint line of credit and to guarantee the Bakery lease, the
Appellant’s appeal should succeed. Even if I accepted the Appellant’s evidence
with regard to the ownership of the house (a contention neither supported by
paragraph 6.01(1) of the Separation Agreement nor independently documented by a
certificate of title), that, in itself, does not establish that the Appellant
earned income from the Bakery. Equally flawed is his further argument that
because under paragraph 8.06 of the Separation Agreement the Appellant released
any interest she might have had in the Bakery, she must have had an interest in
the business. It does not follow that because the Appellant had certain claims
on matrimonial property under the Ontario Family Law
Act that she had an income-earning interest in the Bakery as contemplated
by the Income Tax Act.
[13] All in all, I am unable to conclude that there
is a link between the interest paid by the Appellant and an income-earning
purpose. While in 2005, 2006 and 2007 she paid interest on the line of credit
pursuant to a legal obligation to do so, that obligation is traceable to the equalization
arrangements under the Separation Agreement rather her use of that money to earn income
from a business in her own right. The interest paid was on borrowed money used,
not by her, but by her former spouse to purchase shares in his Bakery business.
Accordingly, the criteria under subparagraph 20(1)(c)(i) are not
satisfied and the appeals must be dismissed.
Signed at Ottawa, Canada, this 4th day of June, 2010.
“G. A. Sheridan”
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