Tetrad Resources Ltd. v. R., [1996] 1 CTC 2622

Beaubier J.T.C.C.: This matter was heard at Vancouver, British Columbia pursuant to the General Procedure on September 15, 1995. The appellant (“Tetrad”) called James Wilson, its sole shareholder; Robert Moeller, C.A., its accountant; and Barbara English, Revenue Canada’s appeals officer in this matter.

At issue are reassessments for 1985, 1986, 1987 and 1988. In 1985 and 1986 loss carry-backs were disallowed. In 1987 Tetrad deducted interest of $40,159 which it claimed to have paid Mr. Wilson. In 1988 Tetrad deducted interest of $101,938 which it claimed to have paid Mr. Wilson. The Minister of National Revenue determined that Tetrad only owed Mr. Wilson interest of $14,054 for 1987 and $15,830 for 1988. The surplus deducted in 1987 and 1988 was treated as an appropriation to Mr. Wilson on which Part XIII tax had not been remitted. Part XIII tax was assessed.

Upon receiving these assessments, the appellant objected and stated that the surplus of interest claimed and disallowed constituted management fees due to Mr. Wilson from Tetrad. This claim formed the basis of the evidence presented in Court. The figures presented by the appellant on this basis were as follows:

Interest: $14,054 (1987) / $15,830 (1988)

Management fees: 25,946 (1987) / 85,963 (1988)

Totals: $40,000 (1987) / $101,793 (1988)

Mr. Wilson was a citizen and resident of the United States of America at all material times. He was born in 1936 and obtained his bachelor’s degree from the University of Southern California and his M.A. in 1969 “at Boulder”. Mr. Wilson resides in Santa Fe, New Mexico. He has been a property developer and has been in the fruit business. He purchased and sold two parcels of land on Quadra Island, British Columbia, near Campbell River. In the summer of 1981 he purchased a grocery store on Quadra Island. Within 10 days of opening it for business he formed Tetrad which owns the grocery store. The store did a volume of well over $2,000,000 per year during the years in question. It did not borrow from a financial institution. Mr. Wilson supplied it with any needed funds. From 1985 to 1988 the store had a staff of 19 to 25 people and was open 362 days each year. The store had a manager at all times. However, Mr. Wilson was at the store each summer and was there “quite a bit” in addition to that during the years in question.

Tetrad retained Mr. Moeller as its chartered accountant in 1985. He has prepared its income tax returns and financial statements for each fiscal year from June 30, 1985 to the present. Mr. Moeller also did accounting work for Mr. Wilson after February 1985. Mr. Wilson reviewed Mr. Moeller’s draft financial statements for Tetrad as they were prepared. Mr. Wilson instructed Mr. Moeller that it would be best if he could get anything due to him from the appellant at a tax rate similar to the U.S. tax rate. Mr. Wilson had received U.S. accounting advice that the U.S. foreign tax credit system worked best in that way.

Mr. Moeller had some non-resident tax experience. However, in the first year he was retained by Tetrad he contacted a Vancouver chartered accountant who advised him that the best way to distribute income to a foreign shareholder was to pay interest. On this basis Mr. Wilson’s promissory notes from the appellant were drafted to yield 14 per cent interest on Mr. Moeller’s recommendation.

After each year end of Tetrad, Mr. Moeller would adjust the figures so that Tetrad had nil income. He would draft the financial statements so that any surplus was recorded as interest to Mr. Wilson on account of the shareholder’s loan. Because Tetrad’s general ledger had no column for interest, funds due to Mr. Wilson were entered in a “wages” column. Mr. Moeller moved any such money due to Mr. Wilson into “interest”. He did this in 1985 with $42,000 “interest”. In 1986 he did it with $25,000 “interest” and in 1987 it was done with $40,159 “interest”.

In 1988 Mr. Moeller’s staff calculated the exact interest for each year from 1982 at the rate of 14 per cent on the shareholder’s loan balance. This portion of their worksheet in Exhibit A-1, Tab 29, reads:

Mr. Moeller explained that Tetrad had a taxable income of $136,000 in 1988. He tried to zero it. Therefore interest was calculated on the shareholder loan balance from 1982 to 1988 inclusive and the “$40,000” shown on the 1987 financial statement as “interest” paid to Mr. Wilson was subtracted. The 1985 and 1986 “interest” was not subtracted. The net “interest” so calculated was $101,793. The $34,207 left over after subtracting $101,793 from $136,000 was shown as wages. Then Mr. Moeller credited $85,963 to the shareholder’s loan and treated $15,830 as a payable which was credited to the shareholder’s loan in 1989.

Mr. Moeller testified that he arrived at these calculations because he had attended a chartered accounting seminar where he learned that his previous system was morally incorrect. As a result, he made the 1988 calculations to correct these moral errors. The end result was that Tetrad recorded $101,793 as interest paid to Mr. Wilson in its 1988 financial statements and income tax returns.

Barbara English was examined respecting the auditor’s review of these procedures. In particular a sheet of Exhibit A-1, Tab 30 was discussed. Part of it reads:

Issues Unresolved:

1. Whether the interest expense disallowed was interest or management fees.

2. Whether the amounts were disallowed because they were unreasonable pursuant to paragraph 20(1 )(c) or subsection 67(1).

3. Whether the disallowance of the application of the 1988 non-capital loss to 1985 and 1986 be reduced to nil. (The changes to the 1988 taxation year resulted in a change from a net loss to net net income.)

Issues Resolved:

Not applicable to this file.

5. Description of Issues

Facts:

The T2 Corporate returns show a claim of $40,159	and $101,938 interest
for 1987 and 1988 taxation years respectively.
The 1988 “Notes to the Financial Statements - 3.	Long Term Debt”

indicate the “Shareholder’s Loan; unsecured, no specified terms of repayment, (1987: ”or specified interest rate) no portion of this amount is included in current liabilities 1987 - $58,459; 1988 - $191,319.” “Included in interest expense is $101,793 paid to the shareholder as interest at 14 per cent per annum on his shareholders loan for 1982 and subsequent years.”

The NR4 supplementaries for 1986 (a photocopy on the file) and 1987 filed with the Minister indicate that interest was paid to a James Wilson (sole shareholder of Tetrad Resources Ltd) $42,000 and $15,830.00 respectively.

The 1988 Shareholder loan account working paper prepared by the accountant indicates a 1982 - 1988 calculation of interest at 14 per cent per annum on the ending balance of the shareholder loan account and the notation “interest set up as 87 payable $40,000 - interest 1982-1988 = $141,793 less $40,000 paid in 1987 $85,963. -wages -$34,207.”. The prior period adjustments for interest disallowed by previous audit was $1985 $21,000.; 1986 $13,750.[thin capitalization rules]. These amounts were debited to the shareholder’s loan account.

The June 30, 1988 adjusting journal entry #17 narrative states: “To record interest on s/h loan from 1982 to 1988 less $40,000 paid in 1987 plus wages for 1988.”

Auditor’s working papers (Ml and M2) shows interest claimed and conclusion that 1987 interest claim was not pursuant to legal obligation to pay, not reasonable in circumstances and not payable in respect of the year. The 1988 only allowed $11,694, of the claim calculated at $14 per cent on month end balances.

May 5, 1991 auditor’s note of the meeting with the accountant indicates the auditor was concerned with the way the interest amount was calculated: “1987 appears to be arbitrary. 1988 14 per cent years 82-88.”

June 5, 1991 proposal letter to accountant the auditor explains that the 1987 and 1988 interest expense will be disallowed as they are not “an amount paid in the year or payable in respect of the year ... pursuant to a legal obligation to pay interest...” He comments on the fact that no minute or resolution concerning the payment of interest on the outstanding balance due to the shareholder was found in the minute book of the corporation.

Ms. English was also examined by Tetrad’s lawyer respecting the Minister of National Revenue’s position that the surpluses were not management fees due to Mr. Wilson. This position is set out in a page contained in Exhibit A-l, Tab 36, concerning which Ms. English was not

shaken in the examination. It reads:

2. All of the information made available by the accountant indicate that not only was the calculation was for interest but also was in respect of the 1982 to 1988 taxation years.

3. All information filed with Minister indicates the amounts expensed or paid were for interest on long term liability — shareholder loan account.

4. There were no shareholder minutes or resolutions or other correspondence that indicates an agreement between the taxpayer and the shareholder to pay management fees to the shareholder in respect of the services performed.

5. A calculation of the net profits of the taxpayer before depreciation and the interest are deducted indicate that the amount of the profit for the year had little to do with the amount claimed:

Taxation	Net profit
Year	Before Int & Ded	Interest Claim
1984	$56,551	Nil
1985	63,793	$42,000
1986	48,326	25,000
1987	84,545	40,159
1988	86,289	101,938

N.B. A previous tax audit resulted in the 1985 and 1986 interest expense being reduced to $21,000 and $11,250 respectively as a result of the thin capitalization rules pursuant to subsection 18(4). It also appears (although this could be a coincidence) that the interest disallowed ($34,750) was set up in 1988 as wage expense ($34,207) and reported by the non-resident shareholder as T4 income.

6. This interest expense does meet the Canadian jurisprudence criteria to be characterized as interest, namely, it was calculated on a day-by-day accrual basis (14 per cent per annum for each taxation year), (ii) it must be calculated on a principal sum (shareholder loan balances); (iii) it must be compensation for the use of the principal sum or the right to the principal sum (loans from shareholder).

7. We do not dispute that the expense was laid out to earn income [paragraph 18(l)(a)] however for Generally Accepted Accounting Principles the income and expenses were not properly matched. The 1982 to 1986 interest expenses were claimed in 1987 and 1988 taxation years.

8. To rename the expenses management fees and allow the claims in 1987 and 1988 taxation years would be retroactive tax planning.

The testimony of both Mr. Wilson and Mr. Moeller concerning the “interest” calculations to nil Tetrad’s income has been described. Mr. Moeller stated that it was his idea. But Mr. Wilson reviewed drafts of the financial statements. He knew the interest rate was 14 per cent and the Court has no doubt that he knew what his shareholder’s loan balance was. He knew that the amounts shown as interest in Tetrad’s financial statements were fiction. But they were to his advantage and they remained that way until the reassessments began. After the 1988 assessment the management fee concept arose. There is no evidence that this was Mr. Moeller’s idea.

The Court had the privilege of seeing the witnesses. Mr. Wilson was carefully dressed in a suit and tie. He is a well educated, self- confident, sophisticated and experienced businessman. His manner is that of one who is accustomed to directing others. He sees that things are done his way and to his satisfaction. He is alert and aware. He was in contact with the Tetrad store by telephone at least once a week when he was not on Quadra Island. He spoke to other employees often about the abilities of the various managers he appointed to oversee the store. He replaced Tetrad’s previous accountant with Mr. Moeller.

Mr. Moeller operates a one-man accounting firm in Campbell River, which is a somewhat remote town on the east coast of Vancouver Island. He appears to be in his 40’s. He sat in Court in an open necked shirt until he was called to the stand whereupon he put on a sports jacket in which to testify. His testimony was quite open about his calculations and his limited knowledge respecting cross-border tax matters. He testified that the “interest” system adopted was his idea based upon accounting advice.

That may be. But that is as far as the Court is prepared to take it. The Court has no doubt that Mr. Wilson was fully aware of what was going on. He saw the drafts of the financial statements. He obtained U.S. accounting advice. He replaced accountants. He hired and fired store managers and checked up on them with other employees. He broke the store down into profit centres for accounting purposes. He had ample business experience. The Court has no doubt that Mr. Wilson knew exactly what the accounting practises were and approved of them.

On the evidence before the Court Mr. Wilson did not care how the accounting was done or how Tetrad paid money out to him so long as it was to his advantage. That, in essence, was his original direction to Mr. Moeller and describes the financial statements and income tax returns of Tetrad which were put in evidence. It also describes the after-the-fact story about management fees.

The story of management fees is a fiction.

The appellant has failed to overcome the assumptions. The appeal is dismissed.

The respondent is awarded its costs.

Appeal dismissed.