Elaine Kernahan v. Her Majesty the Queen (Informal Procedure), [1994] 2 CTC 2314

Rip J.T.C.C.:— Elaine Kernahan, the appellant, has appealed her income tax assessment for the 1990 taxation year, electing under the informal procedure rules of the Tax Court of Canada, on the basis that she is entitled to deduct, in computing her income for the year, the amount of $16,764.57 she paid to National Trust Co. on account of interest on money purportedly borrowed for the purpose of gaining or producing income from a property or business within the meaning of paragraph 20(1 )(c) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act"). In her tax return for 1990 she claimed carrying charges of $8,312; she subsequently requested her 1990 tax return be amended to increase her carrying charges by $16,764.57.

At all relevant times the appellant was married to G. Martin Kernahan ("Kernahan"), the sole witness at trial. Kernahan and the appellant together owned approximately 42 per cent of the issued and outstanding shares of Computrex Centres Ltd. ("CTX") a corporation whose shares are traded on a Canadian stock exchange. At all relevant time, the appellant and Kernahan were two of the three directors of CTX; Kernahan was and is president of the corporation.

In 1982 CTX was experiencing severe financial problems and was in default with several suppliers. Kernahan personally borrowed $100,000 from the Continental Bank of Canada. The loan was secured by a promissory note from Kernahan to the bank and by a collateral second mortgage in the amount of $100,000 on the residence owned by the appellant and Kernahan. The borrowed funds were deposited in Kernahan's bank account and subsequently Kernahan advanced the $1000 to CTX.

Prior to 1982 Kernahan had borrowed other funds from Morguard Trust, the first mortgagee on the residence, for the purpose of lending those funds to CTX. The outstanding balance was $47,000.

CTX's financial position deteriorated further and in 1983 the corporation made a proposal to its creditors under Part III of the Bankruptcy Act, R.S.C. 1985, c. B-3. As part of that arrangement Kernahan had to find a method of repaying his $100,000 loan to the Continental Bank. By letter dated November 4, 1983 Victoria and Grey Trust Co. (“Victoria & Grey") informed the appellant and Kernahan their application for a first mortgage on their home in the amount of $125,000 had been approved. The approval was subject to the outstanding loan balances to the Continental Bank and Morguard Trust being paid in full with the proceeds of the mortgage. The funds were advanced and the loan repaid. In cross-examination Kernahan stated the appellant made payments on the loan from Victoria & Grey since 1983 and she continued to do so in 1990. However he stated that he also paid interest on the mortgage since “I put money into her (bank) account" from which she made the payments to Victoria & Grey.

The original mortgage to Victoria & Grey was registered on December 14, 1983. The mortgage was renewed on at least two occasions and caveats were registered on February 2, 1984 and February 6, 1985 respectively. The mortgage was still registered on title at the end of 1990. In the meantime Victoria & Grey had been acquired by National Trust.

The scene now shifts to 1987. The appellant’s husband was in dire financial straits. He had supported CTX over the years and had personally guaranteed $400,000 of the corporation’s debt to the Canadian Imperial Leasing Co. or the Canadian Imperial Bank of Commerce and $125,000 to Canada Leasing Ltd. He had also advanced his own funds to CTX in 1982 when it was almost in bankruptcy, notwithstanding CTX was a publicly traded corporation. [According to CTX's financial statements for the year ending March 31, 1993, the corporation owed its shareholders approximately $673,000 at the end of 1992; the loans were decreased by $93,000 during the 1993 fiscal year.] Kernahan stated that when the corporation’s shares were issued to the public "there was a possibility that I could protect the only house we had had in the city by having her (i.e., the appellant) own the house outright and also take over the mortgage.” He feared creditors of CTX could go against his home. There is no evidence when the company became a public offering corporation.

By agreement made effective as of September 25, 1987 Kernahan transferred to the appellant his one-half interest in their home so that the appellant became the sole owner of the residence. The consideration for the transfer was one-half of $175,000, which he considered to be the fair market value of the property, payable by the appellant assuming “one-half of (a) $121,000 by assumption of mortgage; and (b) $54,000 by cash or equivalent value in the stock" of CTX. The balance of the mortgage to Victoria & Grey at the time, according to Kernahan, was $121,000. He also stated the appellant "took over the payments of the mortgage" at the time.

The following resolution in writing was passed by the directors of CTX "effective January 1,1990":

The title on the residence at 907 Edinburgh Road S.W., Calgary, Alberta has been transferred from G.M. Kernahan to E.M. Kernahan effective January 1, 1990. The mort- gage on this property has been assumed by E.M. Kernahan and as the funds that were acquired because of this mortgage were injected into Computrex Centres Ltd., the shareholder loan in the amount of $118,370.51 is now transferred from G.M. Kernahan to become a shareholder loan to E.M. Kernahan.

There is no evidence as to the actual date this written resolution was signed by the directors.

Kernahan testified that he had "a major shareholder loan” of $450,000 in the company. In order to protect the appellant's “potential down side in paying the mortgage" he transferred part of the shareholder's loan "which represented the amount of money still owed the mortgage company, namely $118,000, from my personal loan to her loan". Kernahan volunteered the resolution was “badly drafted” and that in fact title or ownership of the residence was transferred three years earlier in 1987.

The transfer of the $118,370.51 is indicated in CTX's accounts by a computer print-out of the company's account "Due to Shareholder-EMK"—"Elaine Kernahan Payable”. (Exhibit A-6). The corporations's fiscal year end is March 31.

Several entries in the appellant’s payable account are shown for April 1992, the first month of CTX's 1993 fiscal period. It appears that on April 30th a journal entry was made to “cancel adjustments of audit entries 1991/1992” and $118,370.51 was credited to general ledger account 2001. The same day another journal entry debited the same amount from general ledger account 2011. On August 31, the appellant’s loan account (referred to as “payable account" in the print out) was credited with $118,370.51 (general ledger 2011). Page 2 of Exhibit A-6 contains an entry, referred to as a pre-audit adjustment, crediting $118,370.51 to the appellant's payable account on March 31, 1993 (general ledger GL 2001). Finally the last item on a copy of a handwritten document (page 4 of Exhibit A-6), referred to as "Due to shareholder” with respect to the appellant, dated March 31, 1992 states in what appears to be bolder writing different from other items; "audit adjustment to mortgage”, crediting $118,370.51 to her payable account; there is no indication when this adjustment was made or recorde . There is no reference to the $118,370.51 in copies of the “Due to shareholder" account of the appellant as of March 31, 1990 or 1991.

Kernahan explained the delay in entering the transfer of $118,370.51 in the company's books of account was due to “problems” with the company’s former auditor and "we had a tax problem because of booking interest and not paying interest".

Kernahan testified he had been trying to collect interest from CTX on the money he advanced but the company was in a négative cash position and he "had to forgive the interest". He explained CTX had a policy to pay interest on shareholder's loans at 1-1/2 per cent over the prime commercial lending rate of the Royal Bank of Canada. There was no documentary evidence this policy was put into practice with respect to the loan payable to the appellant. He stated CTX had recorded interest it did not pay for three years “but had to reverse" the practice because the interest "became taxable whether paid or not". The witness indicated he had been taxed “on interest at one time” although he had not received any interest.

Notes to the financial statements for March 31, 1993 stated that interest was not charged to shareholder's loans either in 1992 or in 1993. No financial statements for previous fiscal periods were produced at trial. Kernahan stated it had been company practice in the past to "book interest and then reverse it". Later on CTX “did not book interest because we couldn't pay it”. Kernahan indicated the appellant was to receive no interest until such time as the corporation had money to pay.

Kernahan insisted the corporation intended to pay interest on the loans from shareholders. He insisted "we booked it for years” but no financial records were produced to corroborate this. In a question from counsel for respondent whether, "when you book interest, would you show it as an amount owing to a shareholder in the shareholder account", Kernahan replied in the affirmative but "[w]e do it informally of course, don't forget because we got caught on that one. And we actually had put it in a statement".

Documents included in Exhibit A-6 reflected weekly payments of $500 by CTX to the appellant during its 1993 fiscal year. [The final item on the document is "pre-audit" adjustment on March 31, 1993 of $118,370.51.] These payments were recorded as reductions in the capital of the shareholder loan to the appellant. Interest, however, was not paid to the appellant. Kernahan again explained that “the policy of the company has been to pay it (interest), if we can".

Kernahan stated the CTX “will show its first profit in 20 years" in 1994. Kernahan explained that CTX was “restructured” in 1984 "in such a way that we knew that with sufficient funds in the company we could expect profit from our operations”. By “funnelling the money in from the house and from whatever source we could get funds” the company was saved and in 1984 we had "great expectations". He explained that in 1990 CTX had its first positive cash flow. He acknowledged that in 1990 there was "no money to pay interest but saw the light at the end of the tunnel”. He expects CTX to have a profit and pay interest on shareholder's loans in 1994. The company has “considerable income” from its Toronto and Ottawa offices and “cash flows this year will be several hundred thousand".

It is the interest of $16,764.51 paid in 1990 to National Trust on the $118,370.51, being the balance of the loan at the beginning of 1990, that is in issue. Was the interest paid by either Kernahan or the appellant or both of them, and if paid by the appellant, was the interest paid on money borrowed for the purpose of gaining or producing income from the loan to CTX?

The appellant says that as a result of the transfer to her of Kernahan's one-half interest in the residence, Kernahan ceased to have a personal obligation to pay interest to the mortgage company. If I understand the argument of the appellant's counsel, Kernahan had a legal obligation, when the loan was first made, to indemnify the appellant for one-half of the principal balance and one-half of the carrying charges, since the loan was made for his investment purposes, and the appellant had only assumed 50 per cent of the obligation. Then, in 1990, the appellant acquired $118,370.51 of Kernahan's shareholder balance; the consideration was her assumption of Kernahan’s half of the mortgage obligation. Thus, she became liable to National Trust, the mortgage company, for 100 per cent of a loan which was originally incurred for the purpose of lending money to CTX.

Counsel for the appellant made an alternative argument which was raised for the first time in his written submission:

[The appellant] assumed the other half of the mortgage obligation for the specific purpose of acquiring an interest-bearing debt owed from a publicly traded corporation at a significant discount from its face amount with an expectation of gaining interest income when the corporation was on its financial feet, and an expectation that the discounted portion of the principal (the difference between what she paid and what the face amount of the obligation of CTX was on its books) would be recovered as well. This would pass the test required, in that it was a "direct" purpose, related to the earning of income which is not exempt from taxation nor a life-insurance policy.

Counsel added that the shareholder loan the appellant assumed was not made for the exclusive benefit of another entity, as the loan bore interest payable to the appellant, and there is an obligation which is admitted in CTX's books of account and financial statements to repay the face amount of the principal to the appellant, “another significant non-exempt benefit purchased by [the appellant] by the direct use of the borrowing.”

The Minister of National Revenue (the "Minister") assessed the appelant on the basis the interest of $16,764.57 was not shown by the appellant to be interest on borrowed money used for the purpose of gaining or producing income from a business or property within the meaning of paragraph 20(1)(c) of the Act. The Minister denies the appellant had a legal obligation to pay any interest.

Kernahan claims he transferred part of his shareholder loan, that is $118,370.51 to the appellant on January 1, 1990. I have some difficulty in accepting the claim as a fact. There is absolutely no evidence to corroborate what, in essence, is the vital element in the appellant’s case. There was no explanation how or when the transfer was actually effected. A written resolution of tne board of directors of the debtor, effective ‘’as of" a certain date, providing “the shareholder loan. . .now transferred from G.M. Kernahan to become a shareholder loan to E.M. Kernahan" does nothing to advance the appellant’s case. One does not transfer, in the case at bar, when the directors signed the resolution. When a corporation is not party to a transaction, a corporate resolution only records what the directors of the corporation have been advised or believe but cannot purport to effect the transfer of property between the other parties. Only Kernahan and the appellant can create the legal relationship they wish to create. The corporation is not a party to the transaction. At times, of course, action may be required by the corporation to record the transaction but only as it affects the corporation.

Entries made by accountants or other persons in the books of account of a corporation simply record what the account opines has transpired; a bookkeeping entry does not create any legal relationship. Thus, for example, when an accountant makes an adjusting entry to an account the adjustment merely records the transaction; the adjustment does not create that transaction. In any event the several entries in CTX'S accounts respecting the transfer of the $118,370.51 record events that purportedly occurred during its 1993 fiscal year. There is no entry in the CTX's books of account recording or even indicating the transfer of the $118,370.51 took place on January 1, 1990, during the company's 1991 fiscal year.

For the appellant to succeed in establishing the transfer of the $118,370.51 took place in January 1990, she faces a formidable task. No evidence before me suggests such date of transfer. It is not necessary to a transfer of property from one spouse to another that it be made in any particular form. All that is required is that the transferor should so deal with the property as to, in this case, divest himself of it and vest it in his wife, that is to say, pass the property from himself to her: Fasken Estate v. M.N.R., [1948] C.T.C. 265, 49 D.T.C. 491 (Ex.Ct.), per Thorson P. There is no evidence that in 1990 Kernahan divested himself of $118,370.51 of the shareholder's loan and vested it in the appellant. Kernahan's income tax returns for 1989 and 1990, for example, may nave been produced to determine whether Kernahan, if he deducted interest paid to National Trust in computing his income prior to 1990, ceased to claim such “deduction” in his 1990 tax return. This may have been one of several indications Kernahan divested himself of the $118,370.51 in 1990.

Kernahan blamed the former accountants of CTX and tax problems at the time for the delay in recording the transfer in the books of the company. He also suggested his drafting of the resolution “effective January 1, 1990” was wanting. These excuses do not help the appellant. To succeed, Kernahan’s testimony, in view of written proof suggesting the contrary, must be bolstered by other evidence that has significant persuasive force of its own and the appellant has not done this: Pallan v. M.N.R. [1990] 1 C.T.C. 2257, 90 D.T.C. 1102 (T.C.C.) at page 2264 (D.T.C. 1107) per Christie A.C.J.

I cannot find that, on the evidence, the transfer of the loan took place on January 1, 1990 or any other time during the 1990 calendar year. Thus I need not consider the other submissions of the parties. Since the appellant did not acquire the loan in 1990 she did not pay interest in 1990 to National Trust on money borrowed for the purpose of gaining or producing income from a property or business. No portion of Kernahan's shareholder loan to CTX was transferred to the appellant in 1990, whether at a discount or otherwise.

Counsel for the appellant submitted that since the appellant was the owner of the residence in 1990, she was under a legal obligation to pay interest to the mortgagee, National Trust. I accept Kernahan's evidence that he transferred his interest in the residence in 1987, there was sufficient documentary evidence establishing the transfer. However it is quite a giant leap to suggest that because the appellant owned the residence, the interest she may have paid to National Trust was on account of a loan incurred by her for the purpose of gaining or producing income from property. Rather, it is my view that her assumption of her husband's liability on the mortgage was the consideration she paid in 1987 for his interest in the residence. Any interest she may have paid National Trust had nothing to do with money borrowed to produce income.

The appeal is dismissed.

Appeal dismissed