David Ludmer, Brian Ludmer, Cindy Ludmer and Ludco Enterprises Ltd. v. Minister of National Revenue, [1993] 2 CTC 2494, 93 DTC 1351

Tremblay, T.C.C.J.:—These appeals were heard on common evidence on July 4 and 5, 1990, November 19, 20, 21, 22 and 23, 1990 and May 6, 7 and 8, 1991 in Montréal, Quebec. The last written submissions of the parties were received in April 1992.

INDEX

1. Point at issue

2. Burden of proof

3. Facts alleged or assumed by the parties and their admission or denial

3.01 Amended notice of appeal of Mr. David Ludmer

3.02 Reply to amended notice of appeal of Mr. David Ludmer

3.03 Amended notice of appeal of Ludco

3.04 Reply to amended notice of appeal of Ludco

4, Facts proven by testimony and exhibits

4.03 Was the interest deductible under paragraph 20(1)(c)?

4.03.4 Witness Irving Ludmer

4.03.4(5) Justinian and Augustus

4.03.4(7)1977 — Review of investments

4.04.1 Are the reassessments invalid?

5. Arguments of the parties

5.02 Appellants' argument on paragraph 20(1)(c)

5.02.2(1)Legal obligation and payment

5.02.2(2)Eligible use

5.02.2(3)Direct and current use

5.02.2(4)Reasonable amount

5.03 Respondent's theory seen by the appellants

5.04 Respondent's argument concerning paragraph 20(1)(c) of the Act

5.04.1 Respondent's general argument

6. Arguments of the parties concerning subsection 9(3) of the Act

6.01 Appellants’ argument concerning subsection 9(3) of the Act

6.01.1 Appellants' general argument

6.01.2 Appellants’ detailed argument

6.02 Respondent's argument concerning subsection 9(3) of the Act

7. Court's determination concerning the interpretation of subsection 9(3) and paragraph 20(1)(c) of the Act

7.01 Interpretation of subsection 9(3) of the Act

7.02 Interpretation of paragraph 20(1)(c)

8. Arbitrary, discriminatory, unfair, “ retroactive” assessments?

8.04.1 Obligation to act fairly

8.04.1(1) General principles

8.04.1(2) Principles of fairness stated by the respondent

8.04.1(3) Application of these principles according to the appellants 8.05 Doctrine of estoppel

8.06.1 General principles

8.06.2 Respondent's policy on deduction of interest

9. Court’s opinion on the various points raised by the appellants in paragraph 8 above

9.01 General principles and case law

9.02 Assessments not arbitrary

9.03 Assessments not discriminatory

9.04 Fair actions

9.04.2 Settlement offer to all

9.05 Estoppel

9.05.1 Audit of appellants

9.05.2 Representation through Information Circular 75-7R3

9.05.3 Appellants’ actions

9.06" Retroactive” assessments

10. Conclusion from paragraphs 8 and 9

11. General conclusion

1. Point at issue

The point for determination is whether each individual appellant rightly deducted various interest expenses totalling $422,868 under 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") for the 1981 to 1985 taxation years.

Each individual appellant argued that these interest expenses were paid on sums of money borrowed for the purpose of earning income from a property, that is in order to purchase shares from two Panamanian corporations, Justinian Corporation S.A. (Justinian) and Augustus Corporation S.A. (Augustus).

The case was the same for Les Entreprises Ludco Ltée (Ludco), but the interest claimed as deductible amounted to $2,955,151.

The appellants also argued that the respondent's determination was not based on paragraph 20(1)(c) of the Act, but on resolution No. 23 of the budget of November 12, 1981, the purpose of which was to limit interest deductibility. However, that resolution was never passed.

Lastly, the appellants argued that the respondent conducted a full audit of their accounting records in 1980 and 1981 and that the head of the tax avoidance section, Mr. John Rowe, had concluded that the interest was deductible. That confirmed a letter to the same effect received from another senior employee of the respondent in May 1978. The appellants relied on those decisions in planning their affairs.

According to the appellants, the respondent acted in an arbitrary and discriminatory manner in 1986 in reassessing the appellants for the years 1981 to 1985. He was not entitled to issue those reassessments after the determinations rendered. The respondent disallowed the interest expense on the ground that the money borrowed was not borrowed for the purpose of earning income, but indeed rather to realize capital gains that resulted therefrom, thus applying subsection 9(3) of the Act.

Alternatively, the respondent argued that deductibility of the interest expenses was in any case prohibited under subsection 245(1) of the Act. He claimed that the purpose of the path taken by the appellants was in fact to circumvent a number of tax provisions, while nevertheless giving the appearance of complying therewith.

Lastly, the respondent denied the appellants’ claim that he was not within his rights in reassessing them in 1985 and 1986.

2. Burden of proof

2.01 The burden is on the appellants to show that the respondent's reassessments are incorrect. This burden of proof arises from a number of judicial decisions, including a judgment of the Supreme Court of Canada in Johnston v. M.N.R., [1948] S.C.R. 486, [1948] C.T.C. 195, 3 D.T.C. 1182.

2.02 In that judgment, the Court ruled that the facts assumed by the respondent in support of assessments or reassessments are also presumed true. The facts presumed by the respondent in the instant case are described in paragraph 3.02 below for the individual appellants and in paragraph 3.04 for the corporate appellant.

3. Facts alleged or assumed by the parties and their admission or denial

3.01 The amended notice of appeal of Mr. David Ludmer (those of Brian and Cindy Ludmer are similar) with the respondent's comments after each paragraph referring to the reply to the amended notice of appeal (R.A.N.A.: reply to amended notice of appeal) reads as follows:

1. The appellant’s [David Ludmer] 1981 to 1985 taxation years have been reassessed on the basis of disallowing as a deduction under paragraph 20(1)(c) of the Income Tax Act, S.C. 1970-71-72, c. 63, as amended (herein the "I.T.A."), the following amounts:

1981	$123,936
1982	$ 89,698
1983	$ 75,282
1984	$ 71,360
1985	$ 62,592
[admitted (paragraph 1 R.A.N.A.)]

2. Included in such disallowed amounts for 1981 to 1983 are accommodation fees paid to a lender of $2,789 per annum in respect of the loans hereinafter described [denied (paragraph 2 R.A.N.A.)].

3. The basic point in contention between the appellant and the Minister of National Revenue (herein the "Minister") is the deductibility of such interest expense [admitted (paragraph 3 R.A.N.A.)].

4, In the year 1977 the appellant acquired a one-third undivided interest in 10,000 shares of Justinian Corporation S.A. (herein "Justinian") for a total consideration of $357,922. Of such amount, $291,255 constituted borrowed funds and $66,666 constituted personal funds of the appellant [admitted (paragraph 3 R.A.N.A.)].

5. In June of 1978, an additional one-third undivided interest in 10,000 shares of Justinian were purchased for a consideration of $380,410. Of such funds, $270,076 constituted borrowed funds and $113,333 constituted personal equity of the appellant [admitted (paragraph 3 R.A.N.A.)].

6. In each case, the appellant purchased fully participating common voting equity shares of Justinian [admitted (paragraph 3 R.A.N.A.)].

7. Such shares were income producing and in fact, yielded an annual dividend equal to one dollar (U.S.) per share in each and every year of the appellant's investment, including the taxation years in question [denied (paragraph 4 R.A.N.A.)].

8. The reassessments are incorrect in the first place, in that no off-setting credit has been given for dividends received on the shares in its taxation years in question in the following amounts:

1981	$7,950 (Cdn)
1982	$8,256 (Cdn)
1983	$8,313 (Cdn)
1984	$8,313 (Cdn)
1985	$9,233 (Cdn)
[denied (paragraph 5 R.A.N.A.)].

9. The appellant’s purpose in making the investment in Justinian was to earn income from property, namely dividends from the said shares [denied (paragraph 5 R.A.N.A.)].

10. During the years in question, Justinian was engaged in an active money lending business and expanded such business activity annually by utilizing retained earnings [denied (paragraph 6 R.A.N.A.)].

11. The appellant did not in any way manage or control the activities of either of Justinian [denied (paragraph 6 R.A.N.A.)].

12. Justinian was managed by an independent board of directors who annually, in accordance with prudent business practices, decided the amount of dividends to be paid to their respective shareholders [denied (paragraph 6 R.A.N.A.)].

13. The board of directors of Justinian was not in any way legally or otherwise restricted in declaring dividends on the shares of the company owned by the appellant and the appellant played no role whatsoever in deciding the dividend policy of Justinian [denied (paragraph 6 R.A.N.A.)].

14. The Minister has seemingly taken the position in respect of the appellant's investment in Justinian that one can only obtain an interest deduction in respect of an investment in fully participating equity shares of a corporation if such corporation pays an annual dividend equal to the full amount of its earnings [denied (paragraph 7 R.A.N.A.)].

15. The mere recital of such a proposition shows how untenable it is, yet this appears to be the position the Minister is advancing in this case [denied (paragraph 7 R.A.N.A.)].

16. The investment by the appellant in Justinian was no different than the investments by millions of Canadians in stocks of Canadian public corporations which pay dividends but retain a substantial portion of their earnings for future reinvestment [denied (paragraph 7 R.A.N.A.)].

17. In fact, it is rare to think of any corporation which has not been built on the theory of reinvestment of earnings, it being an accepted and common sense practice that for a corporation to grow, it cannot pay all its earnings out by way of dividends to shareholders [denied (paragraph 7 R.A.N.A.)].

18. In addition, the appellant paid an accommodation fee in each of 1984 and 1985 of $2,789 in respect of his borrowings to purchase the Justinian shares, which he did not claim as a deduction in computing his income for such years [denied (paragraph 8 R.A.N.A.)].

19. Such fees are deductible pursuant to paragraph 20(1)(e) of the I.T.A. and the appellant's income for such years should accordingly be reduced by such amount [denied (paragraph 8 R.A.N.A.)].

20. The Minister's position in this affair is not based on a correct interpretation of subsection 20(1)(c) of the I.T.A., but rather is based on resolution No. 23 contained in the budget of 12 November 1981 which was intended to restrict the deductibility of interest to an amount equal to investment income [denied (paragraph 9 R.A.N.A.)].

21. Needless to say, such budget resolution was never formally adopted into law and yet, the Minister is not incorrectly administering subsection 20(1)(c) of the I.T.A. in a fashion as if it had been adopted [denied (paragraph 9 R.A.N.A.)].

22. In the years 1980 and 1981, the appellant was the subject of a complete audit by the Minister [denied (paragraph 10 R.A.N.A.)].

23. In the course of the 1980 audit (herein the "audit"), the appellant’s records were provided to the Minister and the Minister, as the result of a requirement for information issued by pursuant to subsection 231(3) I.T.A. was made fully aware of all the appellant’s investments, including the fact that the appellant had, in part, used borrowed money to purchase the shares of Justinian [denied (paragraph 10 R.A.N.A.)].

24. In the course of that audit, Justinian’s counsel informed the Minister of a letter duly signed by the director, Rulings Division, Legislation Branch, dated 3 May 1978, confirming the deductibility of interest expenditures incurred in order to acquire these shares [denied (paragraph 11 R.A.N.A.)].

25. The audit of the appellant was duly completed with the full examination by the Minister of the borrowings by the appellant to purchase the shares of Justinian, without the appellant ever having been reassessed in respect of the deductibility of money borrowed to purchase shares of Justinian [denied (paragraph 11 R.A.N.A.)].

26. In addition, Justinian’s counsel was advised by Mr. John Rowe, the Minister’s representative, in the year 1981, that after a complete and full examination of the appellant's affairs, the Minister had concluded that the appellant who had borrowed money to make his investment in Justinian could deduct interest in respect thereof under the I.T.A. [denied (paragraph 11 R.A.N.A.)].

27. The Minister's representatives knew or should have known that the appellant would rely upon these representations [denied (paragraph 11 R.A.N.A.)].

28. Subsequent to the termination of that audit and the aforesaid statements of Mr. John Rowe, the appellant had no further communication from the Minister in respect of his investment of Justinian until 1985 [denied (paragraph 12 R.A.N.A.)].

29. In arranging its affairs and filing its income tax returns for the relevant taxation years, the appellant acted and relied upon the Minister's representations [denied (paragraph 13 R.A.N.A.)].

30. It was not until 1985 that the appellant received any indication that the Minister would challenge the deductibility of the interest claimed by the appellant in relation to his purchase of shares in Justinian [denied (paragraph 14 R.A.N.A.)].

31. On April 29, 1985, the appellant was advised by the Minister that the Minister was proposing to disallow the interest deduction claimed by the appellant [admitted (paragraph 15 R.A.N.A.)].

32. On January 7, 1986 and April 29, 1987, reassessments for income tax were issued against the appellant for each of the 1981 to 1985 taxation years disallowing the interest expenses claimed notwithstanding that the Minister had, after his examination and return in 1980, studied all pertinent aspects of this matter. These reassessments were not issued in conformity with the Minister's policy as contained in Information Circular No. 75-7R3, which clearly states in paragraph 3(c) thereof that the Minister will not reassess a taxpayer under the following circumstances:

3. All pertinent aspects are studied to determine whether a return is to be

reassessed within the four-year limit. The Department will normally

(c) not reassess where the understatement of tax in the return for the year should have been apparent to the Department, considering the degree of examination and audit that the return received; [denied from "These Reassessments (paragraph 16 R.A.N.A.)].

33. The appellant has reason to believe that he and certain other shareholders of Justinian have been singled out for different treatment in respect of deductibility of interest as opposed to shareholders of other so-called "off-shore funds” [denied (paragraph 17 R.A.N.A.)].

34, The appellant therefore submits that the reassessments under appeal were, in any event, a nullity because:

(a) they were issued on an arbitrary and discriminatory basis and in breach of the Minister's duty to act fairly;

(b) the Minister had no authority to issue the impugned reassessments in light of the representations made by authorized representatives of the Minister to the appellant and on which the appellant relied and acted upon to his detriment [to the effect that the interest expenses were otherwise deductible];

(c) the appellant had in the circumstances legitimate grounds to expect that the Minister would not issue reassessments disallowing the interest deductions claimed; and

(d) in any event, the reassessments were issued in breach of the Minister’s duty to reassess with all due dispatch [denied (paragraph 17 R.A.N.A.)].

3.02 The facts assumed by the respondent are described in paragraph 18 of the reply to the amended notice of appeal. They were admitted, denied or ignored by the appellants as shown below:

18. In assessing the appellant [David Ludmer] for his 1981, 1982, 1983, 1984 and 1985 taxation years, the Minister of National Revenue, respondent, relied, inter alia, on the following assumptions of facts:

(a) In his income tax returns for 1981, 1982, 1983, 1984 and 1985, the appellant

seeks to deduct amounts totalling $422,868 as interest expenses as follows:

1981	$123,936
1982	89,698
1983	75,281
1984	71,360
1985	62,593
TOTAL	$422,868 [admitted]

(b) The amounts claimed and disallowed represent interest paid on borrowed funds to acquire shares of Justinian Corporation S.A. (hereinafter"Justinian" or the "fund"); [admitted]

(c) The funds borrowed by the appellant were not used for the purpose of earning income from business or property, since they were borrowed for the purpose of earning capital gain; [denied]

(d) The clear objective of the appellant was to earn capital gain in lieu of investment income; [denied]

(e) The respondent disallowed amounts of $123,936 in 1981, $89,698 in 1982, $75,281 in 1983, $71,360 in 1984 and $62,593 in 1985, representing interest on borrowed funds to acquire shares of Justinian; [admitted]

(f) Justinian was organized by, inter alia, a Canadian taxpayer and a Canadian law firm; [ignored]

(g) On January 27, 1977, the Canadian law firm sent to the Canadian taxpayer a letter concerning the formation and operation of “Alternational Bond Fund” (name later changed to Justinian); Justinian was later incorporated, incorporating many of the points of this letter and the highlights were as follows:

— No shareholder can own more than 9.9 percent of issued shares;

— Head office of fund to be in a non-taxing jurisdiction;

— Majority of the directors to be individuals resident in a non-taxing jurisdiction;

— Operating manager to be a banking or trust institution resident in a nontaxing jurisdiction;

— Manager cannot delegate investment decisions to the investment counsel;

— All shareholders meetings to take place in non-taxing jurisdictions;

— Investments will be restricted to bonds which are exempt from Canadian and United States withholding taxes;

— Provisions for procedures to be followed in order to ensure that all

trading transactions be deemed to have taken place in the Bahamas;

— The funds would maintain its securities in the U.S.A.;

— Shares are to be redeemed at net asset values;

— There will be no redemption of shares that results in an increase in any one shareholder's interest to 10 per cent or more;

— Proceeds of disposition of shares by sale or redemption give rise to a capital gain; [ignored]

(h) Justinian was incorporated on May 9, 1977, in the Republic of Panama; [admitted]

(i) On August 15, 1977, the organizing meeting of the board of directors was held and the highlights of this meeting are as follows:

— The board of directors authorized the opening of bank accounts as follows:

Morgan Guaranty Trust Company of New York;

The Royal Bank of Canada, Toronto;

Any Canadian Chartered Bank;

Certain U.S. Banks; and

The Trust Corporation of Bahamas Ltd., Nassau; [ignored]

(j) On August 18, 1977, the Canadian law firm sent a letter to the Canadian taxpayer; this letter included, inter alia, a confidential explanatory Memorandum; [ignored]

(k) The dividend policy as stated in the confidential memorandum is as follows:

Initially it will be a policy of the fund to accumulate earnings for reinvestment. In the event that the board of directors of the fund, after giving due consideration to the tax consequences to the shareholders of the fund of a dividend, feel that it is in the best interest of the fund and its shareholders to declare and pay a dividend, payment will be made in United States dollars or any other currency selected by the board of directors of the fund. [admitted]

(l) The investment policy of Justinian was to pay nominal dividends and to reinvest earnings for capital appreciation of its shares; [denied]

(m) The established dividend policy of Justinian was to pay only one dollar per share; [denied]

(n) The appellant who borrowed funds to make his investment knew that, based on the dividend policy of Justinian, the interest expense would create losses for income tax; [denied]

(o) The appellant had the option to redeem his shares at net asset value at specified valuation dates throughout the year; [ignored]

(p) Justinian invested in high quality short term fixed income Canadian securities, the income from which is exempt from withholding taxes; [denied]

(q) Justinian was limited to no more than 50 shareholders; [admitted]

(r) The minimum subscription accepted by Justinian was $100,000 U.S.; [denied]

(s) Justinian operated from an office in Nassau, Bahamas; [admitted]

(t) Justinian was structured in such manner so that the F.A.P.I. rules will not apply (section 91 to 95 of the Income Tax Act) and to create the following tax advantages:

— The fund did not pay tax on its earnings;

— The earnings flowed to the investors in the form of capital gains on the redemption of shares, not in the form of dividends (except for nominal dividends of one dollar per share) and therefore only half taxable;

— Income (except for one dollar per share) was deferred until share is redeemed or sold;

— Interest paid by the investor on loan to finance investment was used to reduce income from other sources; [denied]

(u) The respondent also considered a tax planning document dated September 4, 1976 entitled "Memorandum Respecting the Establishment of a Non- Resident Investment Organization for Canadian Investors” prepared by a Canadian law firm; [ignored]

(v) The said memorandum explained the different ways of setting up the corporation to avoid the F.A.P.I. rules and the various ways of receiving distributions from the organization in order to minimize taxation and provided, inter alia, that:

To provide for optimum Canadian tax results, the bulk of the shareholder's investments should be made in a class of shares redeemable at a premium computed as the value of the underlying assets.

Distributions from the non-resident corporation to the Canadian shareholders would give rise to taxable dividends which would not be eligible for the beneficial gross-up and credit" mechanism provided by sections 81 and 121 of the Income Tax Act. . . Therefore, substantial Canadian income tax would ultimately be payable on the investment income when received by dividend payments, although in the interim substantial earnings could be accumulated on the deferred taxes.

The preferable manner of repatriating the earnings of the foreign investment corporation would be by a redemption of shares. In particular, the deemed dividend rules of section 84 rules of the Income Tax Act would not apply. . .with the result that the accumulated investment income of the foreign corporation would be subject to capital gains treatment [ig- nored]

3.03 Ludco's claim is described in its amended notice of appeal. The latter reads as follows, with the respondent's admissions, denials and other remarks:

1. The appellant has been reassessed in respect of its fiscal years ending September 30, 1981 to September 30, 1985 inclusive, on the basis of disallowing as a deduction under paragraph 20(1 )(c) of the Income Tax Act, S.C. 1970-71-72, c. 63 as amended (herein the' I.T.A."), the following amounts:

1981	$673,551
1982	$651,717
1983	$549,819
1984	$547,027
1985	$533,037
	[admitted]

2. The basic point in contention between the appellant and the Minister of National Revenue (herein the "Minister") is the deductibility of such interest expense, [admitted]

3. In June of 1978, the appellant purchased 10,000 shares of Augustus Corporation S.A. (herein "Augustus") for a consideration of $1,132,663. Of such amount, $830,000 constituted borrowed funds and $302,663 constituted retained earnings of the appellant. [admitted]

4. In December of 1978 the appellant purchased an additional 10,000 shares of Augustus for a consideration of $1,163,574. Of such amount $950,000 constituted borrowed funds and $213,574 constituted retained earnings of the appellant. [admitted]

5. In July of 1979, the appellant acquired 24,500 shares of Justinian Corporation S.A. (herein "Justinian") for a total consideration of $3,016,597. [admitted]

6. In each case, the appellant purchased fully participating common shares of Justinian and Augustus. [admitted]

7. Such shares were income producing and in fact, yielded an annual dividend equal to one dollar (U.S.) per share in each and every year of the appellant's investment, including the taxation years in question, [denied]

8. The reassessments are incorrect in the first place, in that no off-setting credit has been given to the appellant for the dividends received on the shares in its taxation years 1981 to 1983 inclusive, in the following amounts:

1981	$53,484 (Cdn)
1982	$52,944 (Cdn)
1983	$55,159 (Cdn)
	[denied]

9. In addition, and without prejudice to the foregoing, the appellant in the month of May 1983, sold a portfolio of marketable securities having a fair market value of over $12 million to its wholly-owned subsidiary, 2154-7203 Quebec Inc. (herein "2154"). [admitted]

10. Included in such sale, were the shares of Justinian and Augustus owned by the appellant, [admitted]

11. In consideration of such sale, the appellant received consideration including 94 class "B" preferred shares having an aggregate paid-up capital of one dollar and a redemption value of $50,000 per share, [admitted but incomplete)

12. Such shares were dividend paying shares of a Canadian corporation and hence, even if interest in respect of the loans in question was not deductible prior to such exchange (a fact which is not admitted but which is expressly denied), the deductibility of interest after such exchange is unquestionable. [denied]

13. In addition, 2,154 received the following dividends in respect of the Augustus and Justinian shares:

1984	$55,433 (Cdn)
1985	$58,642 (Cdn)
	[ignored and not relevant]

14. The appellant is a corporation whose sole raison d'être is to earn income from a business or property, [denied]

15. A corporation’s entire "existence" is tied to the proposition of earning income. [denied]

16. The appellant was an operating real estate company which, throughout such period, owned 100 per cent of the Boulevard Shopping Centre (herein the "Shopping Centre") in the City of St-Leonard, Quebec. [admitted]

17. The shopping centre was independently appraised in the year 1983 as having a fair market value in excess of $19 million. [ignored] The $3,016,597 borrowed by the appellant in the year 1979 used to acquire the shares of Justinian was financed by a loan from Excelsior Life Insurance Company secured by a mortgage on the shopping centre, [admitted]

18. In fact, such amount was not borrowed by the appellant solely for the purpose of making an investment in Justinian, but rather was borrowed for the purpose of obtaining 30 year financing at an extremely favourable interest rate to be used for future real estate acquisitions and developments, [denied]

19. The money was invested in shares of Justinian as a temporary measure until an appropriate real estate investment could be obtained. [denied]

20. The extraordinary escalation of interest rates after 1979 and the inability to obtain long term mortgage financing in Canada for many years thereafter at a fixed rate, proved that the appellant's foresight in obtaining such a loan was correct. [ignored]

21. The appellant continuously, from 1979 onwards, has sought out real estate investments and in fact has on more than one occasion been frustrated either by expropriation or otherwise from completing planned acquisitions and developments which would have been financed by the Excelsior Life loan. [ignored]

22. This loan was therefore clearly obtained for the purpose of earning income from a business or property and all the interest in respect thereof is therefore deductible. [denied]

23. In addition and without prejudice to the foregoing, the appellant's purpose in making the investment in Justinian and Augustus was to earn income from property, namely dividends from the said shares. [denied]

24. During the period in question, each of Justinian and Augustus were engaged in an active money lending business and expanded such business activity annually by utilizing retained earnings, [denied]

25. The appellant did not in any way manage or control the activities of either of Justinian or Augustus. [denied]

26. Each corporation was managed by an independent board of directors who annually, in accordance with prudent business practices, decided the amount of dividends to be paid to their respective shareholders. [denied]

27. The board of directors of each company was not in anyway legally or otherwise restricted in declaring dividends on the shares of the company owned by the appellant and the appellant played no role whatsoever in deciding the dividend policy of either company. [denied]

28. The Minister has seemingly taken the position in respect of the appellant's investment in Justinian and Augustus that a taxpayer can only obtain an interest deduction in respect of an investment in fully participating common shares of a corporation if such corporation pays an annual dividend equal to the full amount of its earnings. [denied]

29. The mere recital of such a proposition shows how untenable it is, yet this appears to be the position the Minister is advancing in this case. [denied]

30. The investment by the appellant in Justinian and Augustus was no different than the investments by millions of Canadians in stocks of Canadian public corporations which pay dividends but retain a substantial portion of their earnings for future reinvestment. [denied]

31. In fact, it is rare to think of any corporation which has not been built on the theory of reinvestment of earnings, it being an accepted and common sense practice that for a corporation to grow, it cannot pay all its earnings out by way of dividends to shareholders. [denied]

32. The Minister's position in this affair is not based on a correct interpretation of subsection 20(1)(c) of the I.T.A., but rather is based on resolution No. 23 contained in the budget of November 12, 1981 which was intended to restrict the deductibility of interest to an amount equal to investment income. [denied]

33. Needless to say, such budget resolution was never formally adopted into law and yet, the Minister is now incorrectly administering subsection 20(1)(c) of the I.T.A. in a fashion as if it had been adopted, [denied]

34. In the years 1980 and 1981, the appellant was the subject of a complete audit by the Minister. [denied]

35. In the course of the 1980 audit (herein the "audit"), the appellant's records were provided to the Minister and the Minister, as the result of a requirement for information issued pursuant to subsection 231(3) I.T.A. was made fully aware of all the appellant's investments, including the fact that the appellant had, in part, used borrowed money to purchase the shares of Justinian and Augustus. [denied]

36. In the course of that audit, Justinian’s and Augustus's counsel informed the Minister of a letter duly signed by the director, Rulings Division, Legislation Branch, dated May 3, 1978, confirming the deductibility of interest expenditures incurred in order to acquire these shares, [denied]

The respondent denied 34 and 35 and further stated that:

— an audit was conducted by the respondent for the appellant's 1977 and 1978 taxation years and it ended in August 1980;

— the audit in respect of appellant's 1981 to 1985 taxation years began in February 1985;

— offshores [sic] funds, including Augustus Corporation, S.A., and Justinian Corporation, S.A., were subject of scrutiny by the respondent from 1980 to 1985.

37. The audit of the appellant was duly completed with the full examination by the Minister of the borrowings by the appellant to purchase the shares of Justinian and Augustus, without the appellant ever having been reassessed in respect of the deductibility of money borrowed to purchase shares of Justinian and Augustus. [denied]

38. In addition, Justinian’s and Augustus's then counsel was advised by Mr. John Rowe, the Minister’s representative, in the year 1981, that after a complete and full examination of the appellant's affairs, the Minister had concluded that the appellant who had borrowed money to make his investment in Justinian and Augustus could deduct interest in respect thereof under the Act. [denied]

39. The Minister's representatives knew or should have known that the appellant would rely upon these representations. [denied]

40. Subsequent to the termination of that audit and the aforesaid statements of Mr. John Rowe, the appellant had no further communication from the Minister in respect of its investment of Justinian and Augustus until 1985. [denied as stated]

41. In arranging its affairs and filing its income tax returns for the relevant taxation years, the appellant acted and relied upon the Minister's representations. [ignored]

42. It was not until 1985 that the appellant received by indication that the Minister would challenge the deductibility of the interest claimed by the appellant in relation to its purchase of shares in Justinian and Augustus. [denied]

43. On April 15, 1985, the appellant was advised by the Minister that the Minister was proposing to disallow the interest deduction claimed by the appellant. [admitted]

44. On May 7, 1986 and October 2, 1986, reassessments for income tax were issued against the appellant for each of the 1981 to 1985 taxation years disallowing the interest expenses claimed notwithstanding that the Minister had, after his examination and return in 1980, studied all pertinent aspects of this matter. These reassessments were not issued in conformity with the Minister’s policy as contained in Information Circular No. 75-7R3, which clearly states in paragraph 3(c) thereof that the Minister will not reassess a taxpayer under the following circumstances.

3. All pertinent aspects are studied to determine whether a return is to be

reassessed within the four-year limit. The Department will normally

(c) not reassess where the understatement of tax in the return for the year should have been apparent to the Department, considering the degree of examination and audit that the return received; [admitted that reassessments were issued at such dates but otherwise denied the other allegations]

45. The appellant has reason to believe that it and certain other shareholders of Justinian and Augustus have been singled out for different treatment in respect of deductibility of interest as opposed to shareholders of other so-called "off-shore funds", [denied]

46. The appellant therefore submits that the reassessments under appeal were, in any event, a nullity because:

(a) they were issued on an arbitrary and discriminatory basis and in breach of the Minister’s duty to act fairly;

(b) The Minister had no authority to issue the impugned reassessments in light of the representations made by authorized representatives of the Minister to the appellant and on which the appellant relied and acted upon to its detriment [to the effect that the interest expenses were otherwise deductible];

(c) the appellant had in the circumstances legitimate grounds to expect that the Minister would not issue reassessments disallowing the interest deductions claimed; and

(d) in any event, the reassessments were issued in breach of the Minister's duty to reassess with all due dispatch. [denied]

3.04 The facts assumed by the respondent concerning Ludco are as follows at paragraph 24 of the reply to the amended notice of appeal. Ludco variously admitted, denied or ignored them:

24. In assessing the appellant for its 1981, 1982, 1983, 1984 and 1985 taxation years, the Minister of National Revenue, respondent, relied, inter alia, on the following assumptions of facts:

(a) In its income tax returns for 1981, 1982, 1983, 1984 and 1985 the appellant

seeks to deduct amounts totalling $2,955,151 as interest expenses as follows:

1981	$ 673,551
1982	651,717
1983	549,819
1984	547,027
1985	533,037
Total	$2,955,151
	[admitted]

(b) The amounts claimed and disallowed represent interest paid on borrowed funds to acquire shares of Justinian Corporation S.A. (hereinafter" Justinian” or the "fund"), and of Augustus Corporation S.A. (hereinafter “Augustus” or the "fund"); [admitted]

(c) The funds borrowed by the appellant were not used for the purpose of earning income from business or property, since they were borrowed for the purpose of earning capital gain; [denied]

(d) The clear objective of the appellant was to earn capital gain in lieu of investment income; [denied]

(e) The respondent disallowed amounts of $673,551 in 1981, $651,717 in 1982, $549,819 in 1983, $547,027 in 1984 and $533,037 in 1985, representing interest on borrowed funds to acquire shares of Justinian and of Augustus; [admitted]

(f) During 1978, the appellant acquired 10,000 class B shares of Augustus and, for that purpose, it borrowed $830,000 from Mercantile Bank on June 14, 1978; [denied]

(g) During 1978, the appellant also acquired 6,000 class A and 4,000 class B shares of Augustus and, for that purpose, it borrowed $950,000 from Mercantile Bank on December 15,1978; [denied]

(h) During 1979, the appellant acquired 24,500 class B shares of Justinian and, for that purpose, it borrowed $3,036,874 from Excelsior Life Insurance Company on June 27, 1979; [admitted]

(i) On May 11, 1983, the appellant transferred, with other assets, its shares of Augustus and Justinian to its wholly-owned subsidiary 2154-7203 Quebec Inc. (and filed an election undersubsection 85(1) of the Income Tax Act); [admitted]

(j) At that time, the said assets had a fair market value of $12,685,025, including the shares of Augustus and Justinian, which had a fair market value of $8,645,715; [admitted]

(k) In consideration of the said transfer, appellant received demand notes totalling $7,380,000, bearing no interest, a demand note of $605,000, bearing interest and 94 class B preferred shares (total paid-up capital one dollar and total redemption value of $4,700,000); [denied]

(1) The liabilities related to the transferred assets were not transferred. Therefore, the loans used to purchase the shares of Augustus and Justinian remained with the appellant; [admitted]

(m) Neither appellant or 2154-7203 Quebec Inc. repaid the loans above- mentioned; [ignored]

(n) Justinian was organized by, inter alia, a Canadian taxpayer and by a Canadian law firm; [ignored]

(o) On January 27, 1977, the Canadian law firm sent to the Canadian taxpayer a letter concerning the formation and operation of “Alternational Bond fund” (name later changed to Justinian); Justinian was later incorporated, incorporating many of the points of this letter and the highlights were as follows:

— No shareholder can own more than 9.9 percent of issued shares;

— Head office of fund to be in a non-taxing jurisdiction;

— Majority of the directors to be individuals resident in a non-taxing jurisdiction;

— Operating manager to be a banking or trust institution resident in a nontaxing jurisdiction;

— Manager cannot delegate investment decisions to the investment counsel;

— All shareholders meetings to take place in non-taxing jurisdictions;

— Investments will be restricted to bonds which are exempt from Canadian and United States withholding taxes;

— Provisions for procedures to be followed in order to ensure that all

trading transactions be deemed to have taken place in the Bahamas;

— The fund would maintain its securities in the U.S.A.;

— Shares are to be redeemed at net asset values;

— There will be no redemption of shares that results in an increase in any one shareholder's interest to 10 per cent or more;

— Proceeds of disposition of shares by sale or redemption give rise to a capital gain; [ignored]

(p) Justinian was incorporated on May 9, 1977, in the Republic of Panama; [admitted]

(q) On August 15, 1977, the organizing meeting of the board of directors was held and the highlights of this meeting are as follows:

— The board of directors authorized the opening of bank accounts as follows:

Morgan Guaranty Trust Company of New York;

the Royal Bank of Canada, Toronto;

any Canadian Chartered Bank;

certain U.S. Banks; and

the Trust Corporation of Bahamas Ltd., Nassau.

The board appointed Trust Corporation of Bahamas Ltd. as manager and general corporate agent of the corporation.

The board appointed Altamira Management Ltd. as investment adviser: Altamira is a Canadian corporation; [ignored]

(r) On August 18, 1977, the Canadian law firm sent a letter to the Canadian taxpayer; this letter included, inter alia, a confidential explanatory memorandum; [ignored]

(s) The dividend policy as stated in the confidential memorandum is as follows:

Initially it will be a policy of the fund to accumulate earnings for reinvestment. In the event that the board of directors of the fund, after giving due consideration to the tax consequences to the shareholders of the fund of a dividend, feel that it is in the best interest of the fund and its shareholders to declare and pay a dividend, payment will be made in United States dollars or any other currency selected by the board of directors of the fund. [admitted]

(t) The investment policy of Justinian was to pay nominal dividends and to reinvest earnings for capital appreciation of its shares; [denied]

(u) The established dividend policy of Justinian was to pay only one dollar per share; [denied]

(v) The appellant who borrowed funds to make his investment knew that, based on the dividend policy of Justinian, the interest expense would create losses for income tax; [denied]

(w) The appellant had the option to redeem his shares at net asset value at specified valuation dates throughout the year; [ignored]

(x) Justinian invested in high quality short term fixed income Canadian securities, the income from which is exempt from withholding taxes; [ignored]

(y) Justinian was limited to no more than 50 shareholders; [admitted]

(z) The minimum subscription accepted by Justinian was $100,000 U.S.; [denied]

(aa) Justinian operated from an office in Nassau, Bahamas; [admitted]

(bb) According to a document entitled “ Confidential Explanatory Memorandum" dated December 1978, the highlights of the organization of Augustus were as follows:

— No shareholder can own more than 9.9 percent of issued shares;

— Head office of fund to be in a non-taxing jurisdiction;

— Augustus was limited to no more than 50 shareholders;

— Trust Corporation of Bahamas Ltd. was appointed to provide investment management and administrative services;

— Altanational Ltd. was investment adviser to Augustus: the day-to-day operations of Altanational Ltd. were directed by Mr. R. M. Meade who was a principal shareholder of Kauser, Lowenstein & Meade Ltd. which owned all of the outstanding stock of Altamira Management Ltd., a Canadian corporation engaged in the administration of securities portfolios and in providing investment counseling services;

— Majority of the directors of Augustus to be individuals resident in a nontaxing jurisdiction;

— The fund will not be managed by Canadian resident individual;

— Manager can not delegate investment decisions to the investment counsel;

— Investments will be restricted to bonds which are exempt from Canadian and United States withholding taxes;

— Provisions for procedures to be followed in order to ensure that all

trading transactions be deemed to have taken place in the Bahamas;

— Shares are to be redeemed at net asset values;

— There will be no redemption of shares that results in an increase in any one shareholder's interest to 10 per cent or more;

— Proceeds of disposition of shares by sale or redemption give rise to a capital gain; [ignored]

(cc) Augustus was incorporated on October 31, 1977 in the Republic of Panama; [admitted]

(dd) The investment policy of Augustus was to pay nominal dividends and to reinvest earnings for capital appreciation of its shares; [denied]

(ee) The established dividend policy of Augustus was to pay only one dollar per share; [denied]

(ff) The appellant who borrowed funds to make his investment knew that based on the dividend policy of Augustus the interest expense would create losses for income tax; [denied]

(gg) The appellant had the option to redeem his shares at net asset value at specified valuation dates throughout the year; [ignored]

(hh) Augustus invested in high quality short-term fixed income Canadian securities, the income from which is exempt from withholding taxes; [denied]

(ii) The minimum subscription accepted by Augustus was $200,000 U.S.; [denied)

(jj) Augustus operated from an office in Nassau, Bahamas; [admitted]

(kk) Justinian and Augustus were structured in such a manner so that the F.A.P.I. rules will not apply (section [sic] 91 to 95 of the Income Tax Act) and to create the following tax advantages:

— The fund did not pay tax on its earnings.

— The earnings flowed to the investors in the form of capital gains on the redemption of shares, not in the form of dividends (except for nominal dividends of one dollar per share) and therefore only half taxable.

— Income (except for one dollar per share) was deferred until share is redeemed or sold.

— Interest paid by the investor on loan to finance investment was used to reduce income from other sources [denied].

(II) The respondent also considered a tax planning document dated September 4, 1976 entitled "Memorandum Respecting the Establishment of a Non- Resident Investment Organization for Canadian Investors" prepared by a Canadian law firm; [denied]

(mm) The said memorandum explained the different ways of setting up the corporation to avoid the F.A.P.I. rules and the various ways of receiving distributions from the organization in order to minimize taxation and provided, inter alia, that:

To provide for optimum Canadian tax results, the bulk of the shareholder's investments should be made in a class of shares redeemable at a premium computed as the value of the underlying assets.

Distributions from the non-resident corporation to the Canadian shareholders would give rise to taxable dividends which would not be eligible for the beneficial” gross-up and credit” mechanism provided by sections 81 and 121 of the Income Tax Act. . . Therefore, substantial Canadian income tax would ultimately be payable on the investment income when received by dividend payments, although in the interim substantial earnings could be accumulated on the deferred taxes.

The preferable manner of repatriating the earnings of the foreign investment corporation would be by a redemption of shares. In particular, the deemed dividend rules of section 84 rules of the Income Tax Act would not apply . . . with the result that the accumulated investment income of the foreign corporation would be subject to capital gains treatment. . . [ignored]

4, Facts proven by testimony or exhibits

4.01 During the inquiry, which lasted ten days, the parties summoned ten persons as witnesses and filed more than 360 exhibits constituting 19 volumes totalling more than 4,000 pages. In addition, the written arguments totalled more than 800 pages, not including the 145 cases and articles of doctrine constituting seven volumes to which counsel referred.

Lastly, the ten volumes of transcripts covering the investigation comprised 2,231 pages.

4.02 This mass of documents and swarm of necessarily contradictory ideas centred on two points, that is whether the interest in issue was deductible within the meaning of paragraph 20(1)(c) of the Act, and, if not, whether the reassessments made were arbitrary, discriminatory and unlawful because of the information given to the appellants in 1978 and 1981 by the respondent's senior authorities to the effect that the said interest was deductible. The appellants apparently planned their affairs on the basis of this information.

4.03 Was the interest deductible under paragraph 20(1)(c)?

4.03.1 According to Exhibits A-101 to A-120 (volume 4, pages 1830 to 1869), the interest claimed by the appellants and disallowed by the respondent was itemized as follows:

4.03.2 The appellants’ general position was that the interest expenses incurred and paid by each of the appellants on loans taken out at financial institutions by the latter in order to purchase 44,550 common shares of Justinian and 20,000 common shares of Augustus were deductible under paragraph 20(1)(c) of the Act. These expenses consisted of sums paid in each of the relevant taxation years to discharge a legal obligation to pay interest on "borrowed money used for the purpose of earning income from . . . property", and, consequently, those expenses were deductible in computing the appellants' income for each of the taxation years in issue under paragraph 20(1)(c) of the Act.

4.03.3 The respondent's general position is described at paragraphs 26 and 27 of the reply to Ludco's amended notice of appeal and at paragraphs 20 and 21 of the reply to the amended notice of appeal of each of the individual appellants.

The respondent argued, on the one hand, that the interest claimed was not on sums borrowed for the purpose of gaining or producing income in accordance with paragraph 20(1)(c) of the Act.

He alleged, on the other hand, that these claimed interest expenses constituted disbursements or expenses with respect to a transaction or operation which, if allowed, would unduly or artificially reduce the appellants’ income, and, consequently, those expenses were not eligible under subsection 245(1) of the Act.

4.03.4 Witness Irving Ludmer

4.03.4(1) The engineer Irving Ludmer, born in 1935 and holding a degree in physical engineering from McGill University in 1957, was the appellants’ main witness. He is the father of the three individual appellants, Brian, born in 1960, Cindy, born in 1962, and David, born in 1967. He had held shares of Ludco from the date of its incorporation on November 4, 1975 (Exhibit A-1) until August 31, 1981. On that date, the said shares were purchased by 109395 Canada Inc. (hereinafter"109395"), an investment company which Irving Ludmer had incorporated and in which he held all the shares (Exhibit A-2).

The company 2154-7203 Québec Inc. (hereinafter "2154"), incorporated on May 6, 1983, was a wholly-owned subsidiary of Ludco (Exhibit A-3).

4.03.4(2)Mr. Irving Ludmer's administrative and financial experience began after he left university in 1957 with his employment with the company Steinberg. He worked there until 1971, first as a "maintenance engineer”, then climbing the ladder to assistant to the vice-president and general manager, development and expansion (TR. 07/04/90, pages 51-53).

After leaving Steinberg in 1971, the witness founded his own business by purchasing four shopping centres in Lachine, St-Jean, St-Laurent and Sherbrooke over the years (TR. 07/04/90, pages 56-58).

In 1983, he renewed his relationship with Steinberg and became its president. When he left in 1989, Steinberg’s annual revenue was $5 billion, and the shares were valued at $1,300,000,000.

On August 22, 1989, Steinberg was sold to Soconav Inc. and to the Caisse de dépôts et de placements (TR. 07/04/90, pages 67-75).

In cross-examination, Mr. Irving Ludmer stated that he had acquired considerable knowledge and experience of financial markets at Steinberg (TR. 11/19/90, pages 185-86).

4.03.4(3)ln 1971, a trust was established for the benefit of the three children of Irving Ludmer. The latter had proxies enabling him to act for his children. He also became his children’s guardian in accordance with a Superior Court judgment on April 29,1975 (Exhibits R-5 and R-7).

4.03.4(4) In October 1977, Mr. Irving Ludmer was informed of the existence of investment companies ("bond funds”) doing business outside Canada and managed by Trust Corporation of Bahamas [sic] (hereinafter "T.C.B."). These were the companies Justinian and Augustus. He had been informed of them by Mr. Arnold Steinberg, an acquaintance of the witness who was also one of the directors of Justinian and of Augustus (TR. 07/04/90, pages 87-88, and 11/19/90, pages 197-199 and 222).

4.03.4(5) Justinian and Augustus

Justinian was incorporated on May 9,1977 and Augustus, on October 31, 1977 under the statutes of the Republic of Panama (Exhibits A-4, A-6, A-145 and A-149).

In addition to being managed by T.C.B., Justinian and Augustus were also advised by Altanational Ltd. (hereinafter "Altanational") and subsequently Altamira Management Ltd. (hereinafter "A.M.L.") (TR. 07/05/90, pages 45-47, Exhibit R-50, tab 8).

T.C.B. was a wholly-owned subsidiary of Roywest Banking Corporation Ltd. (hereinafter Roywest"), which was controlled by the National Westminster Bank (hereinafter "N.W.B.") of the United Kingdom and by the Royal Bank of Canada. N.W.B. was an international bank. T.C.B. then became Roywest Trust Corporation (Bahamas) Ltd.. T.C.B. provided "investment management and administrative services" to Justinian and Augustus (Exhibit A-4, volume I, pages 23-35, Exhibit A-13, volume II, pages 332-39, examination of Ludmer, transcript of uly 4, 1990, pages 90-93).

Altanational was a corporation incorporated under the statutes of the Commonwealth of the Bahamas, and, starting on October 1, 1978, it provided investment counselling services to Roywest, Justinian and Augustus, thus succeeding A.M.L., and was managed by Ronald M. Meade. A.M.L. was a corporation incorporated under the statutes of Canada which provided professional management services and managed "bond funds”, better known as the “Altamira funds” (Exhibit A-4, volume I, page 42, examination of Ludmer, transcript of July 4, 1990, pages 88-89; Exhibit A-13, vol. Il, pages 331-40; Exhibit A-16, vol. Il, pages 354-361; cross-examination of Ludmer, transcript of November 19, 1990, pages 205-07).

Altamira Preferred Dividend Funds Inc./Fonds de Dividende Privilégiés Altamira Inc. (hereinafter"Altamira") was a public company specializing in investments in preferred shares (cross-examination of Ludmer, transcript of November 22, 1990, pages 91-93).

Ronald M. Meade (hereinafter" Meade") was a partner in the firm of Kauser, Lowenstein & Meade Ltd., doing business in Montréal, which managed, inter alia, the investments of A.M.L. Meade and A.M.L. had an impeccable record ("sterling record") at the time as financial investment advisers (examination of Ludmer, transcript of July 4, 1990, pages 88-89; cross-examination of Ludmer, transcript of November 19, 1990, page 205).

4.03.4(6) Justinian’s business began on October 1, 1977 and that of Augustus on December 1,1977. In September 1977, Mr. Irving Ludmer, after a request to T.C.B., received a copy of Justinian's prospectus and subscription forms.

Justinian’s prospectus contained, inter alia, the following information:

Organization and purpose

The fund is an investment company incorporated as a sociedad anonima under the laws of the Republic of Panama on May 9, 1977, to provide a vehicle for investment by a select group and limited number of persons who are neither citizens nor residents of the United States of America. It is intended that the fund be a” private company" as that term is used under the securities laws of the several provinces of Canada. . . .

The purpose of the fund is to make available to a select group of sophisticated investors, who are neither citizens nor residents of the United States, continuous professional investment supervision of assets in a portfolio consisting predominantly of debt obligations. It is anticipated that the fund will invest in Canadian and United States dollar denominated securities in both the primary and secondary securities markets in Canada and Europe. . . . (page 30)

Objective

The fund will invest principally, though not exclusively, in debt obligations. The fund's objective will be to achieve a reasonably high and constant income by means of investing primarily in fixed income securities. To this end, the fund will endeavour to select securities which present the best opportunity for providing above-average yield combined with long-term capital appreciation, with due regard to the exercise of prudence in protecting the shareholder's capital

Authorized capital

The authorized capital of Justinian was 900,000 class-A common shares with par value of one dollar (U.S.) per share, and 100,000 class-B common shares, of 100,000 common shares [sic] with par value of one dollar (U.S.) per share, with a maximum number of shareholders limited to 50. (page 27)

The sole restrictions on the rights of the class-A shares of Justinian described in the prospectus were that one person could not hold more than 9.9 per cent of that class of shares. In the event that a shareholder held more than 9.9 per cent of the capital stock issued in class A, those surplus shares were automatically transformed into class B shares. The class B shares carried no voting rights or rights to receive notices of shareholder meetings, but carried all the rights and privileges also enjoyed by the holders of class-A shares, (pages 28-29)

Dividends

Dividend policy

Initially, it will be a policy of the fund to accumulate earnings for reinvestment. In the event that the board of directors of the fund, after giving due consideration to the tax consequences to the shareholders of the fund of a dividend, feel that it is in the best interests of the fund and its shareholders to declare and pay a dividend, payment will be made in United States dollars or any other currency selected by the board of directors of the fund, (page 32)

Under the head Tax, appears the following concerning, inter alia, Canadian taxes:

The receipt by a Canadian shareholder of a dividend from the fund would be taxable to such shareholder. It should be noted that such shareholder would not be entitled to the benefits of the "gross up" and "credit mechanism" applicable to dividends received from Canadian corporations pursuant to sections 82 and 121 of the Act.

Upon the redemption by a Canadian shareholder of shares of the Capital Stock of the fund, any gains realized would be subject to the capital gains tax regime provided by subdivision C of division B of Part I of the Act with the result that 50 per cent of such gains (measured as the excess of Redemption price over original cost) will be included in income to be taxed at ordinary rates. It should be noted that the deemed dividend rules of section 84 of the Act do not apply to redemptions of share capital by a non-resident corporation and the shareholder-benefit or appropriation rules of section 15 would have no application to the redemption of shares of the capital stock of the fund.

Augustus's prospectus was identical to that of Justinian. Augustus's dividend policy was explained as follows:

Dividend policy

The fund will accumulate the major portion of its earnings for reinvestment. However, in each year that the fund has earnings it is anticipated that the board of directors of the fund will declare and pay a dividend to shareholders of some portion of the fund's earnings. Payment of dividends will be made in United States dollars or any other currency selected by the board of directors of the fund.

(Exhibit A-6, volume I, pages 138-47)

The prospectuses of Justinian and Augustus contained in substance a number of clauses of the “Articles of Incorporation” (hereinafter “letters patent") of Justinian and Augustus. The two companies have appreciably the same provisions concerning the objects, classes of shares and dividends. The same is true of their by-laws. Those of Justinian contained the following clauses:

Objects:

To hold, invest and reinvest its assets, and in connection therewith to hold part or all of its assets in cash, and to purchase or otherwise acquire or sell, assign, negotiate, transfer, exchange or otherwise dispose of or turn to account or realize upon and trade in, upon margin or otherwise, upon all forms of securities, including without limitation of the generality thereof, stocks, shares, bonds, debentures, notes, or other obligations, whether subordinated, convertible or otherwise, and certificates, receipts, warrants or other instruments representing rights to receive, purchase, etc.

Capital stock:

The authorized capital stock of the corporation shall consist of 1,000,000 shares of two classes: 900,000 class A shares par value one dollar (U.S.) per share; and one hundred thousand (100,000) class B shares, par value one dollar (U.S.) per share. The stated capital of the corporation shall be at least equal to the sum of the aggregate par value of all issued shares having par value plus such amounts as from time to time by resolution of the board of directors may be transferred thereto.

Classes of shares:

Each class A share is entitled to one vote as provided in article ninth hereof. Each class A shareholder shall be entitled to vote, personally or by proxy, at all shareholders’ meetings whether ordinary or extraordinary, class B shares shall not be entitled to vote on any matter, either individually or as a class. class B shareholders shall not be entitled to notice of shareholders’ meetings.

Dividends:

The board of directors shall determine the use to which the net earnings of the Corporation shall be put and may in its sole and absolute discretion determine whether distributions will be made therefrom in the form of dividends.

Dividends declared may be paid in United States Dollars or any other currency selected by the board of directors and may be paid at such places and times as may be determined by the board of directors. The board of directors may make a final determination of the rate of exchange applicable to translate dividend funds in the currency of their payment.” (Exhibit A-145, volume XI, pages 1996-2016)

[Emphasis added.]

Justinian’s by-laws included, inter alia, the following clause:

Dividends:

To the extent permitted by law, the Board shall have full power and discretion, subject to the provisions of the articles of incorporation of the corporation and the terms of any other corporate documents or instrument binding upon the corporation, to determine what, if any, dividends or distributions shall be declared and paid or made. (Exhibit A-147, volume XI, pages 2023-42)

[Emphasis added.]

Mr. Irving Ludmer received no representations from Justinian and Augustus other than those related in the prospectuses.

4.03.4(7)1977: Review of investments

4.03.4(7.1) According to Mr. Irving Ludmer, 1977 was a year in which the investment policy had to be reviewed both for Ludco and for his children.

In 1977, Ludco was careful to diversify its investments in fields other than real estate. Construction of his shopping centre on Boulevard Pie IX, in Montréal, had been completed in May 1977 (cross-examination of Ludmer, transcript of November 19, 1990, pages 187-188; examination of Ludmer, transcript of September 4, 1990, pages 63 ff., pages 86 ff., page 94).

In 1975, Brian, Cindy and David Ludmer disposed at a profit of their shares in Iberville Developments Ltd. (hereinafter Iberville"), a company in which they had been shareholders since 1971 and which had developed, inter alia, the shopping centre "Les Galeries de la Capitale" in Québec City (Exhibit R-5, pages 2 and 6; examination of Ludmer, transcript of July 4, 1990, pages 61 ff., pages 86 ff.).

The taxable portion of this capital gain was used to purchase a 15-year income-averaging annuity contract (IAAC). The annual payments from this annuity were then included in the computation of income of each of the recipients. An advance ruling issued by Revenue Canada confirmed the

ceptance of this planning arrangement by Revenue Canada. Brian, Cind

David thus had capital which they were interested in investing. The annual payments received from the IAAC equalled $63,938.52 for each of them, Brian, Cindy and David (cross-examination, transcript of November 20, 1990, pages 44-47, 51-56; Exhibit A-67, volume VII, page 1352; Exhibit A-68, volume VII, page 1368; Exhibit A-72, volume VII, page 1441; Exhibit R-4).

4.03.4(7.2) Ludmer identified a number of risks and factors which he had assessed before reaching the decision to purchase the shares of Justinian and Augustus, including, inter alia:

(a) managers' experience and expertise;

(b) portfolio management policy ("investment policies") with regard to changes in interest rates;

(c) changes in foreign exchange rates;

(d) financing costs;

(e) immediate realization of profits;

(f) tax considerations;

(g) Panama; and

(h) other choices.

Given the importance of Mr. Irving Ludmer's testimony concerning these risks and factors, as well as the appellants’ intention, the decision reached, the purchase of the shares and the financing, since counsel for the appellants summarized these points well at paragraphs 67 to 130 in the argument outline, I believe it is pertinent to cite them:

(a) Managers

67. Justinian and Augustus had no "track record", but Ludmer relied on that of A.M.L. and Meade, who was to advise T.C.B., which managed the business of Justinian and Augustus. A.M.L.'s "track record" was well known and its past success made the difference. The performance of A.M.L.'s executives was superior to that of other managers of similar portfolios.

Examination of Ludmer, transcript of July 4, 1990, pages 137-38

Examination of Ludmer, transcript of July 5, 1990, page 135

Exhibit A-25, volume V, page 1031

Exhibit A-26, volume V, pages 1060-61

68. The managers must have known how to make money, that is when to buy and sell bonds. A.M.L. and Meade had proven themselves in this regard, as had the Royal Bank and N.W.B.

Examination of Ludmer, transcript of July 4, 1990, pages 104-05, 115-16

Examination of Ludmer, transcript of July 5, 1990, pages 6-9

(b) Investment policy

69. The business of Justinian and Augustus consisted essentially in purchasing bonds in order to earn interest income and a profit upon their resale, taking into account changes in interest and bond markets. [1]

Cross-examination of Ludmer, transcript of November 19, 1990, pages 190-92

70. The risks inherent in this type of business stemmed from three factors, that is the term of the bond (e.g. maturity one year, five years, etc.), the quality of the bond depending on the quality of the issuer (e.g. “ blue chip” or"junk") and the changes in interest rates which influenced the market value of the bond security. The risk was therefore essentially linked to the management of the securities purchased by Justinian andAugustus, to the yield of the bonds and to their maturity (long or short term). [2]

Examination of Ludmer, transcript of July 4, 1990, pages 96-98, pages 110-120

Examination of Ludmer, transcript of July 5, 1990, pages 6-9, pages 16-19, pages 25-27, 29-30.

71. The prospectuses described in detail the cyclical management policy of Justinian and Augustus, i.e. purchase of long-term bonds when interest rates were declining and purchase of short-term bonds when increasing, and Ludmer was satisfied with that.

Exhibit A-4, vol. I, pages 43-44

Examination of Ludmer, transcript of July 4, 1990, page 119.

(c) Changes in exchange rates

72. Changes in currency exchange rates were likely to affect the yield of the various bonds and their market resale value or purchase cost.

Examination of Ludmer, transcript of July 5, 1990, pages 4-6, 31-36

Examination of Ludmer, transcript of July 4, 1990, pages 212-13

73. The shares of Justinian and Augustus were sold in U.S. currency which was supposed to be purchased with Canadian dollars. The fluctuations in these currencies influenced the cost of the shares and their yield in the form of dividends or capital gains.

Examination of Ludmer, transcript of July 4, 1990, page 212

(d) Borrowing costs

74. These purchases were allegedly financed in part by loans from financial institutions, and this factor was considered by Ludmer:

Q. In this decision to invest, did you factor in the fact that you were borrowing money?

A. Absolutely.

Q. Would you tell the Court how that impacted on your decision to make this investment?

A. Yes, well when you borrow money, you leverage, as it's known, in order to make an investment. It was sort of like buying a stock on margin which is really what this is. You're buying stock at Bell Canada for example, you buy it on margin so that's called leverage. And essentially I made the decision to do so because I believed that the earnings would exceed the cost of money.

And that's when you leverage.

Q. The earnings from the shares?

A. The earnings from dividends and the share disposition at the end would exceed the cost of funds. It's the same thing that I’ve done all my life in the real estate business. If I take the mortgage, the purpose of taking the mortgage would become stupid if I didn't think that I was going to be able to earn more money when I had to pay the banks. I’d have to be pretty stupid, I don't know how you can win doing that.

So essentially, it’s what's known as leverage and I felt that the leverage would be positive and that's why we borrowed. Now, in this particular case we left a certain amount of equity there such that if that thing dipped, the bank wouldn't call the stock the first day. And that’s something that you don't want to happen to you so you put in some equity and the rest is leverage. And you go from there.

And so I thought that while leverage increases risk, I thought that it was a good risk to take.

[Emphasis added.]

Examination of Ludmer, transcript of July 4, 1990, pages 159-61.

See also examination of Ludmer, transcript of July 4, 1990, pages 161-64.

Examination of Ludmer, transcript of July 5, 1990, pages 6-7, 13-14

75. This risk was minimized by the fact that the loans granted by the bank contained clauses permitting the appellants to crystallize [sic] the interest rate and that the appellants had alternative sources of income enabling them to absorb any deficit between the working capital generated by the shares and their financing cost.

Examination of Ludmer, transcript of July 5, 1990, pages 30-32

(e) Immediate realization of profits

76. Ludmer wanted part of the profits of the companies in which he invested to be distributed immediately in the form of dividends so as to reduce his risks:

A. Well the risk is not a risk associated with dividends, the risk is one that to the extent that you have made money I mean, theoretically on paper, that you've made money. You never really made money until you are going to a bank and deposit the cheque and even then, the cheque goes through and doesn't come back NSF, so then you've made money.

So what I'm trying to say is that in any investment you don’t look at the paper and say I’ve made a ton of money until such time as you actually see the cash and that's why it's important to see that you get some of the money, some of the winnings, if you would, on paper anyways that you collect them on an annual basis and get dividends.

Q. What's the objection of collecting them at the end, sir?

A. What's the objection of collecting

Q. Collecting them at the end?

A. Oh, you don’t know if they're going to be there. I mean when somebody gives you a report and says that you're up two dollars a share, that's very nice, that's today. Tomorrow that could be gone, so it's nice to see some of the money that supposedly is part of the winnings come in and go into a bank. Then you know you've got it. Until you cash that cheque, you don't know what you have.

It looks good, it might look good but there's a big difference between appearances and the end result.

We've all seen stocks that have risen to $100 a share and somebody says: “Well it’s up to $100, why shouldn't I wait it's going to get $200”. But it doesn't necessarily get to $200. It sometimes goes to $50. So you say: "Why didn't I sell at a $100?

And so you know that's the old game. It’s nice to take some off the table in other words.

Q. And how did that concern translate in your decision?

A. How did that concern translate?

Q. Yes.

A. Well you know, the truth of the matter is we were getting dividends and so that was some income. We were watching the management and their decisionmaking and how they were doing and so on and so forth, through the monthly reports that we looked at a number of them yesterday. And those were coming in on a regular basis.

And it had to tie in with your own view of, you have to have a view I mean, you have to have a belief of where's the world going to, otherwise you're just totally out of it. And you shouldn't be investing altogether.

So when you look at all of this, you look at interest rates, you look at what seems to be happening, you look at what you have to pay the banks for your loans, et cetera. How comfortable are you with that amount of money owing on a monthly basis. You have to write a cheque et cetera. So all of that put together makes you decide whether you’re staying in or you're jumping out.

Examination of Ludmer, transcript of July 5, 1990, pages 10-12

(f) Tax considerations

77. The tax incidence of these investments was not the appellants’ first consideration. The first consideration was their intrinsic profitability. If the investment did not appear profitable, the tax considerations were of no real importance, except perhaps with regard to the deductibility of losses.

Examination of Ludmer, transcript of July 5, 1990, page 136, pages 185-86

i. Justinian and Augustus

78. Justinian and Augustus did business outside Canada, and their profits were therefore not taxable in Canada, thus enabling them to maximize the sums at their disposal either for the purposes of reinvestment or for the purposes of distribution to their shareholders in the form of dividends. In either case, the shareholder's return through dividends or capital gains on the shares was increased and thus more attractive. Taxes were thus deferred for the shareholders, who would be taxed when dividends were paid and/or when their shares were sold.

Examination of Ludmer, transcript of July 4, 1990, pages 95-101, 104-06, 147-48

ii. Shareholders

79. The shareholders of Justinian and Augustus were taxable on the dividends received [sic], without being able to benefit from the computation of the tax credit based on grossed-up dividends. This consideration had no real impact.

Examination of Ludmer, transcript of July 4, 1990, pages 148-50

80. The possibility of deducting interest expenses from the appellants’ income was a factor which Ludmer considered in his decision both for Ludco (pages 34-41) and for Brian, Cindy and David (pages 41-59). In each of the cases, the investment's profitability was the predominant consideration.

Q. May I suggest or am I correct in saying that there's a link or connection between the I.A.A.C. of $63,000, taxable each year, and the purchase of the shares of Justinian, so that you consider that it made sense to secure a huge deduction as interest against the income of each child?

A. No, I think you’re incorrect.

Q. Did you consider the interest deduction in order to determine which

amount you would buy for each children, of Justinian in the foreign funds?

A. To determine how much I would buy?

Q. Yes?

A. The answer is no. I mean it was part of an overall consideration. The most important thing of which was what was I buying and who was managing it and what were the risks and so on.

Insofar as how much money was borrowed, then obviously whether one had an I.A.A.C. or one didn't have an I.A.A.C., one could have paid the interest from money that you had. You didn't have to buy an I.A.A.C. in order to set up a revenue to pay the interest, so you could have kept the cash and paid the interest.

So I would say that the two are not linked.

Q. Why did you borrow, sir, one point six million and buy two point two million of shares instead of, let's say, one million or two point two million or three million?

A. Because the comfort level.

Q. The term, comfort?

A. . . . the comfort level, meaning of what you feel comfortable. How much does a person feel comfortable with in one single investment. So, just to go through your point for a minute, I obviously felt comfortable in this investment with whatever the amount was. Two point two million you say? Of which one point six million was borrowed? That was something I felt comfortable with.

I could have done the exact same thing with Canadian investments and borrowed money to invest in Bell Canada, for that matter had I wished to. It's a matter of comfort and what you want to do. And I think we mustn't mix the whole question of interest deductibility with these funds which happen to be one particular type of investment.

One can get deductibility of interest just as well on Canadian stocks or, for that matter, in buying IBM in the United States with borrowed money in Canada.

Q. Is it a factor that made you comfortable that you could deduct interest?

A. No, no. The comfort factor was the overall return which I could earn from dividends and profit on disposition versus the borrowed money. So it was my belief that the overall return from both dividends and profit on disposition would exceed the cost of money.

Q. Am I correct in saying that there's a connection with the level of taxable income of the children that you expected for the future years, so that you expected to reduce their income taxes by the interest deduction?

A. You know, you've asked me that question and I answered how I made the investments for the children.

Q. Is it a factor that you considered?

A. It's always a factor. I explained before, whether I go into a real estate deal and there's depreciation, whether I buy mining flow through shares and get depletion and exploration allowances, I don't know that is a crime in this country to get deferral and when it is, I’m guilty.

Q. So I understand that in that specific instance you did consider that aspect?

A. It was one of the considerations but more important than that, and I continue to stress it: is the essence of the investment itself.

[Emphasis added.]

Cross-examination of Ludmer, transcript of November 20, 1990, pages 56-59.

81. Taxation of the profit resulting from disposition of the shares as a capital gain, half of which would be included in the computation of the shareholders' income, was a neutral factor since it was common to any investment in the shares of any company: [3]

Q. Did this in any way impact on your decision to buy, sir?

A. No, because this is exactly the same thing as a Canadian corporation.

Q. In what sense, Mr. Ludmer?

A. Well I mean again, let's go back and say that instead of this whole fancy Justinian thing, the company was set up right here in Canada, where you would get dividends and you would be taxed on the dividends, so that you would have the gross-up and the credit on the dividends and ultimately when you sold unless you know, you were a trader in securities or something, you would make a capital gain, so you know, on the disposition, so in that regard I don't know why this would make me feel any more favourable or less favourable. It’s exactly the same as a Canadian company.

Q. Mr. Ludmer, wasn't this a fact that you would get a more attractive treatment

if this were a capital gain a factor in your decision to buy these shares?

A. Well let me, let me explain it, because I think you know, I’ve answered it and I'd like to explain it again. The factor in buying these shares is such that one is looking to the risk of management and the dividends and ultimately, hopefully a profit on disposition.

And that is really again I stress no different than what I would do for any Canadian based corporation.

[Emphasis added.]

Examination of Ludmer, transcript of July 4, 1990, p. 150-53.

(g) Panama

82. The fact that Justinian and Augustus were Panamanian companies was not a factor which Ludmer considered important since their securities would be kept elsewhere than in Panama.

Cross-examination, transcript of November 19, 1990, page 194.

(h) Other choices

4.03.4(7.3)

83. Ludmer considered various other forms of investments at the time, but deemed Justinian and Augustus more profitable. Those other investments included, inter alia:

(i) stocks;

(ii) mutual funds; and

(iii) bonds and term deposits.

Cross-examination of Ludmer, transcript of November 19, 1990, pages 187-90, 192-94.

Re-examination of Ludmer, transcript of November 22, 1990, pages 51-52, 54-56, pages 129-30, Exhibits R-29, R-30, R-31.

i. Stocks

84. In his analysis of the various investment opportunities, Ludmer considered the past [sic] experience, history and management of the companies, the quality of their directors and the quality of their assets.

Cross-examination of Ludmer, transcript of November 19, 1990, page 189

85. The dividend yield of the companies trading on the stock market varied, the average standing at around three per cent. (For example, Du Pont of Canada paid a dividend of 1.17 per cent of the value of its shares in 1983.)

Examination of Ludmer, transcript of July 5, 1990, pages 141-46.

Exhibit A-27, volume VI, page 1067.

Exhibit A-28, volume VI, page 1069.

Exhibit A-29, volume VI, page 1070.

Cross-examination of Ludmer, transcript of November 21, 1990, pages 133-34.

86. At the relevant time, no company of Ludmer's knowledge trading its shares on the stock market paid a dividend equal to the interest paid to the banks:

Q. Now to your knowledge Mr. Ludmer, in those years were you aware of any shares apart from these which would pay that kind of return or that kind of dividend?

A. To my knowledge I’m not aware of a single Canadian company that paid this kind of dividends.

Q. Now, are you aware of any corporation who even paid a return or the cost of borrowing money today?

A. No, as I said earlier you know, the typical range that we find in Canadian corporations is nowhere near today's rates of interest you know, I mean you're not getting — companies just don’t pay that kind of money in dividends. So we're talking today about 14 A per cent prime. I'm not aware frankly of any companies that are paying you know, 14 A per cent dividends on common stock on top of that.

Examination of Ludmer, transcript of July 4, 1990, pages 162-64, 165.

87. As to the so-called “blue chip" stocks, Ludmer explained his position as follows:

Q. What about blue chip, sir?

A. Well the blue chip question is one that, again, I felt that after having managed, putting my toe in the water as it, to try a few of these companies on my own, that I decided that the best thing for me would be to become a shareholder of somebody else's operation and run my business and let them run the investment business. So that I look for expertise rather than to continue to do my own investing in stocks, bonds, commodities and all that.

Because it takes a lot of knowledge and I felt that it takes people to watch on the daily basis. And I felt that I was better off sticking to what I knew and I got kind of busy with a few other things that I had to do and I felt that it was best to leave that to experts.

Q. Now I would you, how would blue chips fair if you would compare them by way of return?

A. Well, again, blue chips would probably pay both, you would be going to both, to dividend and a gain on disposition, same way. I mean if you bought Bell Canada Enterprises, which is considered a blue chip or Canadian Pacific, there is no way that you would be satisfied with the return just on the dividend of Bell Canada Enterprises. You're looking to make a profit too.

So you’re looking for both, the dividend and the gain on the disposition. So in that sense, blue chips or not blue chips, you’re really looking for the same thing, it's all a matter of comfort level on the risk. The lower the quality of the stock, the higher the risk, but eventually maybe you could make money faster, it all depends if you pick the right ones.

Q. And would this apply also if you compare blue chip stocks or common stocks to the Justinian or Augustus shares?

A. Well, you know, Justinian and Augustus shares I would not label as being as blue chip as Bell Canada, I mean, it’s not quite the same thing. I would say that Justinian or Augustus would be riskier than Bell Canada.

Q. And how would you compensate a higher risk?

A. I would want a higher return.

Re-examination of Ludmer, transcript of November 22, 1990, pages 130-33.

ii. Bonds

88. Ludmer explained his position on bonds as follows:

Q. What about bonds?

A. Well bonds is what Justinian and Augustus was doing. So, essentially, you had professional management brought to the management of bonds as opposed to me trying to do it myself.

Q. If I may just go back one step, Mr. Ludmer, why would you consider the Justinian investments or the shares in Justinian and the shares in Augustus a higher risk?

A. A higher risk?

Q. Yes?

A. Well because, again, if the people running it made the wrong call and, I think I explained that earlier, if you go long term on the bond, let's say you buy a 25 bond and you buy it to yield ten per cent, and suddenly interest rates shoot up to 15 per cent, well you've lost a lot of money on that bond.

It’s not just that, you're only going to get ten per cent and others are getting 15 per cent. Try and sell that bond after that! You will sell for a heck of a discount, because people want 15 per cent, they don’t want ten. So if this one only pays ten they're only going to give you $70 or something for it, not a $100 anymore. So you’re going to lose a lot of money.

Q. So it would be fair to say then that this was not a no-risk investment?

A. Oh, it was, you saw the bank document wherein they said : But you're only putting up 17 per cent of the equity, what happens if you lose more than the 17 per cent?" Remember that? We looked at it today. So they knew that there could be a loss.

Re-examination of Ludmer, transcript of November 22, 1990, pages 130-33. iii. Term deposits

89. Ludmer thought it appropriate not to convert all his investments into term deposits for the following reasons:

A. Sure. The reason that I didn't put all the money into term deposits is because with term deposits you receive a low overall return. And it's considered relatively safe, but on the other hand you get relatively low returns. So what you have to do is get a balance and I already had real estate, I had some term deposits and now I decided that I would take some money and put it into larger investments.

In other words, fixed income investments, which are bonds, some stocks, some commodities and so on, to try to get a balance portfolio. And that's why I didn't just sit on term deposits.

Re-examination of Ludmer, transcript of November 22, 1990, pages 129-30.

4.03.4(7.4) Intention and return

90. The appellants acquired the shares of Justinian and Augustus in order to realize a profit through dividends paid annually and through the capital gain realized on their disposition:

Q. Now when you, and I mean your children and your corporation Ludco, when you bought in Justinian what kind of return were you contemplating at the time?

A. Well, you look at the return consistent with two things and that is, one of them is the risk and so to answer your question. . .

Q. No, let me rephrase. What form of return, I'm sorry, form of receipt, what kind?

A. What kind of return as opposed to what return?

Q. What form of return?

A. Well, the form of return that you get is twofold, one you get dividends and the other at the end hopefully if the thing has gone up in value instead of down in value, you'll make a profit on the disposition. That means either on the sale of the shares or upon their redemption.

[Emphasis added.]

Examination of Ludmer, transcript of July 4, 1990, pages 101-02, 104 and 184.

91. The appellants anticipated a profit in the form of dividends and capital gains on the shares which would be realized upon disposition:

Q. How did you establish, Mr. Ludmer, that these were or this would be a profitable investment at the time?

A. Well I couldn't establish that they would be a profitable investment, I could only establish in my own mind that the odds were favourable for the investment to turn out profitable. The only, hindsight they say is 20/20, nothing else. So "you place your money and you take your chances", it’s an old expression.

And but essentially again it had to do with the management, who was going to make the decisions and also the type of investment philosophy that was going to brought to bear here. All of which I testified to this morning.

Q. Alright, now the profit elements in determining the profitability of the

investment, what are the elements used to take into consideration?

A. Well, what you take into consideration is really any investment that you go into. You first look at what is the perceived risk and so you Say, given that kind of a risk I believe that I would like to be able to see a return of so much and so much. Or I shouldn't be taking the risk if the reward is not going to be in keeping with the kind of risk you're taking.

So that's a subjective thing. Each person has to come to their own conclusions in that regard. The second way in which you then calculate it is only after you see how the performance evolves and that is and what's known as the present value method of discounted cash flow or conversely what's known as the internal rate of return.

And maybe I’ll just explain that for a minute. Is that what you do is you take into account the time value of money so that if you get dividends at the end of year two and you get a dividend at the end of year three, et cetera, et cetera and then you make a certain profit let’s say at the end. The money you get at the end per dollar is not as import-ant as the dollar that you earned years earlier. Because of the reinvestment potential of money.

So what you have to do is take all of those, that stream of money that you got, discount it back to the present value in order to determine how you really came out of this thing.

So the only way that you could really determine how you did is by doing this kind of an internal rate of return calculation at the end. And so it was my feeling that between the dividends and the eventual profit on disposition, that I would certainly have a return that would be in keeping with the kind of risk that I was taking investing in this kind of a corporation.

[Emphasis added.]

Examination of Ludmer, transcript of July 4, 1990, pages 127-28, 131, 199.

92. The combination of these two forms of return was to compensate the appellants for all the risks which they took and to exceed all costs generated, including the interest incurred on the loans needed to purchase their shares:

Q. Me Guy Du Pont: Mr. Ludmer, at another day, in cross-examination, you were asked whether you expected dividends on these investments, the Justinian or Augustus, whether these dividends would ever equal the interest costs or expenses you have incurred and I believe your answer was that you did not expect the dividends to equal the interest expenses. Would you tell this Court why, sir?

A. Yes. We just heard and I testified earlier, the approximate average dividend on stocks is about 3.5 per cent per annum in Canada and if one were to look at the interest rates and one were to go back the 20 years in question that Your Honour has on that schedule, I think you'll find that the dividends never equal the interest rate.

So one would wonder why do people invest in stocks and they invest in Canadian stocks or any stocks for the reason that the combination of dividend income and gains on disposition exceeds the cost of money. And that’s why we have what they call margin accounts in Canada, cause people borrow money to invest in stock market. And the reason again is because the combination of the dividends together with the gains on disposition make up more, hopefully, than the cost of money, otherwise you lose your money.

So people borrow because they expect it to be more, that combination, and that's why. Because in the side, the average yield, for example, on the Japanese stock market, on the Tokyo Stock Exchange, is 0.51 per cent.

HIS HONOUR: 1.5?

A. Point five per cent. And the cost of money, today, is eight per cent and people leverage, even in Japan, cause they expect that the value will go up in addition to the dividend, so that they'll make the combination of dividends and gains on disposition. That's why people do that. That's why I I did it.

[Emphasis added.]

Re-examination of Ludmer, transcript of November 22, 1990, pages 107-09.

A. Well, essentially, one must remember that in the background of my business career, that I had borrowed an awful lot of money at various stages. ‘For example, in the real estate field, at one point in Iberville Developments, back in the early seventies, my partner, Marcel Adams, and I had borrowed and owed the banks, at that time, probably $35,000,000 in building various properties.

So leverage was not something new to me. Prior to that, subsequent to that rather, in the middle seventies, we're talking about one particular mortgage here, which was a mortgage on real estate, on property that I own myself, which was in excess of $9,000,000.

So the idea of leverage was not something that was new to me. And the reason that I leveraged in this particular investment was because I felt that the combination of income from dividends and gain, on profit on disposition would be such that it would exceed the cost of money. And I said in my early testimony, and I'll repeat it again, that there's no advantage in losing money, even it helps you tax ways, it's still a lost.

I mean, you cannot make money at losing money, at least I’ve never discovered it other than that. So that’s why, cause I thought I would make more money together between dividends and profits on disposition than the cost of the money.

Q. You've also indicated to my learned friend that in assessing the viability of this investment, the economic viability of this investment, you took into consideration the interest deductibility or the factor, or the fact that the interest was otherwise deductible against Ludco and the children’s income. Was that the only factor to consider in making your decision?

A. Absolutely not. And the factors were first: What was the investment? Who was going to manage the investment? How risky was the investment? And what were the chances to earn income and profit? It's only after you've decided all of that, that you decide whether you want to buy more. And the only thing that the leverage does for you, is give you the opportunity to buy more of it.

But you don't go into something because it’s deductible. I mean I can lose money anywhere and it's deductible, so what good is that. That doesn't do much for you.

Q. So is it fair to say then that it wasn't the main factor?

A. Absolutely.

Re-examination of Ludmer, transcript of November 22, 1990, pages 113-16.

93. The return which Ludmer anticipated from the purchase of the shares in Justinian and Augustus was as follows:

Q. On what figures did you rely to assess the perfectibility [s/c] [4] of Justinian in the first place?

A. Well, you can't really rely on any figures because they were no figures. You rely on history and the track record of the people who are going to make the decisions. And then you decide whether you're going to become an investor or you're not going to be an investor.

Q. Sir, except the documents that you previously filed with the Court, are there any other documents upon which you did rely to assess Justinian or Augustus?

A. Not that I'm aware of.

Q. Did you seek advice from somebody else except Mr. Steinberg, in order to decide to buy or not, to invest or not in those offshore funds?

A. No, there was, I have always relied on my own business advice.

Cross-examination of Ludmer, transcript of November 19, 1990, pages 199-200.

Me Daniel Verdon: What kind of a return or yield did you expect from Justinian?

A. Well, it varies. You don't go into these things looking for particular yield because it varies. The interest rates vary up and down and you hope that the management will do the right thing in terms of lengthening and shortening term, etc., to make money for you. So the yield that you're looking for has to be better, obviously, than what you feel you could do yourself and also in keeping with the times.

Q. Well, considering the risks involved?

A. Yes?

Q. You explained previously that depending on the risk you expect a greater or smaller return?

A. That's right.

Q. So considering the risks involved in Justinian and Augustus, what was your target? Did you have any target?

A. Oh, but your target varies because any investment is a live thing so that if, for example, interest rates are six per cent. . . .

Q. What I mean is your target in '77 and '78, when you decided to invest?

A. Yes, I don’t remember what rates were exactly at that time.

Q. It was depending on prevailing interest rates at that time?

A. Of course.

Q. So let's say, for example, that the interest rate would be ten per cent, your

target would be, well ok, considering the risk it would be ten and more?

A. Yes, let's say, for example, that a ten per cent interest rate, you could, if you bought a certificate of deposit at a bank, you wouldn't get ten, because the banks want to make a profit. So you get something less than ten. If you decided to buy a bond that was thirty years, let’s say, you might've gotten 13 at that time.

However, if interest rates were to go up your bond would lose money, as I explained last time. So you need somebody who knows what to do, in order to give you a better return than the standing cost of money. And it varies from month to month, year to year and so on.

Q. But in assessing the funds, Justinian and Augustus, I understand you correctly that you were considering the prevailing interest rate at that time, nor as to, well, my target should be around that in such type of investment?

A. That's right.

Q. How did you figure you could obtain such a return in Justinian and Augustus?

A. Well, the way I figured you could get such a return is because, again, the management was going to handle the portfolio according to the theory of cyclical management, which means, and I'm going to simplify, that if you think interest rates are going to go down, you shorten the term of your investments. If you think, I mean you lengthen the term of your investments so that a long bond, which pays a coupon that is better that the prevailing bonds would pay, is worth more. If people want to buy it from you, they'll give you a profit.

Conversely, if your rates are going to go up then you shorten the term, because if you got a long term commitment at a low rate and rates are higher than that, nobody wants to buy your bond unless you give it to them for a lower price than the face value of the bond. So that's the cyclical management bond.

In addition to that you’ll have to worry about the credit, reliability of the company or the government or whatever it is that says they owe you the money. That's the creditor in effect or the debtor, I should say, in this situation. You become a creditor of that company and if they can’t pay you back because they ran into trouble you've got another problem.

And then if you're going to put some of the portfolio into U.S. investments, now you have another problem, because you have a currency exchange problem. When you go in the currency might be one and when you come back out, if the currency is only worth a half, then even though you made money in U.S. terms, you've lost money in Canadian terms. So there's various risks involved and that’s why, unless you’re going to make it a career and devote your time to that, you're better off in the hands of experts.

[Emphasis added.]

Cross-examination of Ludmer, transcript of November 19, 1990, pages 198-203.

94. Ludmer explained the application of his "internal rate of return" formula used to assess the profitability of his investments:

Q. Now in your formula, your internal rate of return formula, do I understand then from your testimony Mr. Ludmer that both these factors were factored in or taken into consideration, the dividend potential of the shares and the earnings at the end or the growth at the end of your investment?

A. Yes, they're taken into consideration but let me explain to you that I couldn't do the calculations because how do I know what dividend or what earning the fund is going to make. I mean I have no way of knowing that in advance. All I can tell you is that you look at it from that perspective and you say to yourself if things go reasonably well and assuming that I look at the past performance of the management of this and so on, what can I honestly hope to make out of this thing, I mean I didn't expect that I was going to triple my money every year. It wasn't that volatile a thing here.

So and with that given this whole thing, could that produce an internal rate of return that would make sense and be commensurate with the kind of risk that was being taken here.

And that's what I have to decide but there was no way I could do the calculation because I didrï't know whether they'd make or lose you know. The only way they can declare dividends anyways is from earnings. They first have to make earnings.

Examination of Ludmer, transcript of July 4, 1990, pages 136-37.

95. These purchases were not made solely for the purpose of realizing a profit on disposition of these shares:

Q. Mr. Ludmer, the Minister alleges in one of his assumptions:

. . . that the clear objective of the appellant Ludco was to earn capital gain in lieu of investment income.

A. Well I obviously deny that because the objective was to earn both income through dividends and profit upon disposition.

Q. Paragraph (c) Mr. Ludmer the Minister alleges:

. . . that the funds borrowed by Ludco were not used for the purpose of earning income from a business or property since they were borrowed with the purpose of earning capital gain.

A. I deny that too on the same basis that I just stated.

Q. Mr. Ludmer, paragraph (t) page 60, states: “The investment policy of Justinian was to pay nominal dividends and to reinvest earnings for capital appreciation of its shares.

A. That is not so because for two reasons: No. 1, the dividends were not nominal and we saw dividends of many corporations which were around the one per cent level, No. 1. And No. 2, the dividend policy was stated in the explanatory memorandum which was the dividends would be declared in the — there would be reinvestment, it said there would be some of the funds, some of the retained earnings would be reinvested.

But there was nowhere did it say that the dividend would be nominal and that the capital appreciation of the shares was the target because who knew and who was prepared to guarantee that there would be capital appreciation of the shares.

Q. Paragraph (u) Mr. Ludmer, the Minister alleges or assumes it's the fact;

That the established dividend policy of Justinian was to pay only a dollar a share.

A. That is incorrect as well and nowhere was that ever included in any explanatory memorandum, nor was there ever to the best of anybody's knowledge, nor did it occur frankly because if the board had ever made that kind of a policy decision, they would have had to communicate that to the shareholders. Which was never done.

Q. Paragraph (v) Mr. Ludmer:

Ludco who borrowed the funds to make its investment knew based on the dividend policy as described that the interest expenses would create losses for income tax.

A. That is just ridiculous.

Q. For what reason sir?

A. Well, because Ludco has never had a loss in its entire existence. So that to create losses, it just — well anyway it just is not correct, period.

Q. In other words, Mr. Ludmer, if I understand this paragraph correctly, did Ludco get involved in these share purchase in the purchase of these shares in Justinian and Augustus to make losses?

A. Ludco never goes into investments to make losses. Because if Ludco went into investments to make losses, Ludco would have a very tough time being here today.

Q. Even if these losses are otherwise tax deductible sir?

A. Even if the loss is deductible I mean, it doesn't do you very much good if it’s a loss. Very tough to make money losing money. There are maybe a few people who know how to do that but I haven't figured that one out yet.

[Emphasis added.]

Examination of Ludmer, transcript of July 5, 1990, pages 196-99.

96. It was important for the appellants to obtain dividends so as to minimize their risk:

Q. Mr. Ludmer, if I may backtrack a bit. You have indicated in your testimony as I understand it that the dollars that you would hope to get at the end of your investment which I assume is the growth in shares if any?

A. Yes.

Q. Is not as attractive as the money you'd be drawing by way of dividend or it would represent less money for the shareholder?

A. No, what I'm saying is, is that a dollar earned later on is not as valuable as a dollar earned sooner.

Q. Why?

A. Because of the discounting effect of money. The other. . . .

Q. Assuming you bought these shares and kept them for five years how would that formula apply?

A. Well the formula would apply that if I was going to wait till the end, let's say, for my money, I would certainly want to get more money at the end than I would have gotten over the years. Because otherwise I've lost. I mean I’m not talking about this now from an income tax consideration. I’m just talking now about returns, pre tax, let’s call it that way okay.

And so when you look at that, the sooner you get back the money, the better, okay. Just from the money, the discounted value of money is worth. And. . . .

Q. Any other reason why you would want your money sooner?

A. Well I certainly would want some dividends because see, why do people look fora dividend when they buy a Canadian stock, it’s no different from this I mean you know, in terms of, "Do you want a dividend, don't you want a dividend?" Why shouldn't you buy a Canadian stock and hope that the board of directors will never declare a dividend so that the money can keep building up in the company and then when you sell it you'll have a bigger profit at the end. And if that is capital gain well then your tax rate is less than if you got it in by virtue of dividend.

And yet stocks that declare dividends are more popular and are generally better received in the investment community than stocks that don't. And the reason for that is that you invest money in a company, be it Canadian or otherwise, and you say you know, "I'd like to see some of that money come back, I don't want to bet all the money, all the time without having a chance to take some of the money off the table.” So it's like a poker game.

When you invest and you want to see that you don't keep betting everything double or nothing all the time. So you do want to see some return and that's why people want dividends. And I'm not talking about the widow now that needs the dividends to eat. I'm talking about you know, she doesn't get a dividend, how does she live? I'm not talking about that now.

I'm talking about why would an investor favour a company that pays a dividend. And the reason is that that investors [sic] says: “Look, I put some money in they can only pay a dividend from retained earnings so I've made some earnings, why don't I take some of that off the table and then go on and let the rest be reinvested.” But at least I'm not gambling everything every year, year after year.

And that's the reason why people like to see a dividend. So. . . .

Q. What about you Mr. Ludmer?

A. Me, I'm no different from other people. Yes, I also like to see a dividend.

Q. And was this a factor in your decision to buy?

A. It always is a factor in any decision that I make is how do I get some of the money off the table and not gamble everything all the time. And secondly how do, who is running this thing and what is it investing in, is a big, big factor for me.

Q. And it was a factor instrumental in your decision to buy the Justinian and Augustus shares in '77?

A. Absolutely and while we're at it, let me again stress what I stressed this morning. With me, well as far as I'm aware of the tax advantages or disadvantages in certain situations you first have to look at the merits of the investment itself. Otherwise you're not going to have to worry about the tax as I said earlier. You're going to lose your money and that will be fine. After that you don't have to worry about how much tax you're going to pay.

So the point I’m trying to make is that it again goes back to the fundamentals of sound investment and sound business.

Q. Now in your formula, your internal rate of return formula, do I understand then from your testimony Mr. Ludmer that both these factors were factored in or taken into consideration, the dividend potential of the shares and the earnings at the end or the growth at the end of your investment?

A. Yes, they’re taken into consideration but let me explain to you that I couldn't do the calculations because how do I know what dividend or what earning the fund is going to make. I mean I have no way of knowing that in advance. All I can tell you is is [sic] that you look at it from that perspective and you say to yourself if things go reasonably well and assuming that I look at the past performance of the management of this and so on, what can I honestly hope to make out of this thing, I mean I didn't expect that I was going to triple my money every year. It wasn't that volatile a thing here.

So and with that given this whole thing, could that produce an internal rate of return that would make sense and be commensurate with the kind of risk that was being taken here.

And that’s what I have to decide but there was no way I could do the calculation because I didn't know whether they'd make or lose you know. The only way they can declare dividends anyways is from earnings. They first have to make earnings.

Q. When you bought in 1977 and 1978, were you aware of this company's past track record?

A. Not the company, I was aware of the track record of Altamira Management which was really going to make the difference.

Q. To your knowledge Mr. Ludmer, did the company have any track record at the time?

A. Well I believe that the company, we read earlier today, was set up in May of 77 and so since. . . .

Q. And your first purchase was. . . .

A. Summer of 77 so it wasn't based on the track record of the company that I was buying, it was based on the track record of the management.

[Emphasis added.]

Examination of Ludmer, transcript of July 4, 1990, pages 132-38; see also pages 146-50.

Decision

97. The qualities that distinguished Justinian and Augustus from other types of investments were as follows:

Q. What features made Justinian and Augustus so attractive for you?

A. Well, the features that made it attractive were first and foremost the management by a company as reliable as the Trust Corporation of the Bahamas.

Q. Did you ever deal before with that Corporation?

A. Never, but it was the Royal Bank and the National Westminster Bank. Now the Trust Corporation of the Bahamas a wholly owned subsidiary, 50-50 of the Royal Bank of Canada and the National Westminster Bank of England. Now these are two huge banks. Then if you look at the list of Directors of these banks, of these, rather the Trust Corporation of the Bahamas and what they call Roy West Trust, there was really, it was a who's-who. So that first and foremost I knew nobody was going to abscond with any of the money.

Secondly, in the person of Ron Mead I thought that we had one of the finest bond managers that I was ever able to track out. And so those were the two biggest features and then I would say that there was a tax advantage in terms of the lower current taxes to be paid in Panama. Now again that's not an evasion of taxes, it’s, it leaves more money in the Panamanian company for distribution to Canadians by virtue of either dividends or profits on disposition when the Canadians would pay tax in Canada.

Cross-examination of Ludmer, transcript of November 19,1990, pages 191-92, 205-06.

98. Ludmer concluded as follows concerning the evaluation of all these risks and factors:

So when you look at all of this, you look at interest rates, you look at what seems to oe happening, you look at what you have to pay the banks for your loans, et cetera. How comfortable are you with that amount of money owing on a monthly basis. You have to write a cheque et cetera. So all of that put together makes you decide whether you're staying in or you're jumping out.

Examination of Ludmer, transcript of July 5, 1990, page 12.

So after having checked that part out, I decided that given the expertise of the money managers, given the reliability of the people involved and the way the money managers intended to take risk which is all spelled out in the confidential memorandum as well here and which we might talk about a little later.

Examination of Ludmer, transcript of July 4, 1990, page 95.

Q. Going back to the overall investment now, and in dealing with these five risk elements you've identified in your testimony this morning, what factors in your decision in 1977 to invest compensated those risks?

A. Well the factors really were the experience of the Altamira group in managing specifically this, bonds. I mean this is where they made their reputation. The fact that later on they were able to get in to become managers of equities and so on was based on their reputation in managing bonds and what they had done in the previous years in managing bonds.

And had it not been for the people because you're asking me now as opposed to generically I am big believer that it's people that make successes or failures. And it's not how fancy the furniture is in their office or how many titles they have, it really is the people.

So I've always in my life took my investments on the backs of who are the right people, rather than the, you know, the fact that somebody comes with a title, Lord so and so or whatever. That could be inherited, it doesn't mean that it [sic] necessarily the right person.

Q. Any other factors, Mr. Ludmer?

A. Well I think that the only other factors I could say is I was comfortable with the debt in that there were other sources of income to make up for the difference between the dividends and the interest payments. So I didn't expect to get foreclosed by the banks.

In addition to that you'll notice that in the loan agreements, if I thought interest rates were going to go wild, I did have the right to lock in to a term borrowing rather than a demand loan borrowing with the banks. So that was right in the loan agreements which you have here with the banks. So that if I thought that rates were going to go through the sky, I could lock in to a loan and not have the bank says: “Well, you know money is tight, we want our money back, so give us back our money."

And you could lock into even the rate if you want by doing B.A.’s which are Banker's Acceptances and things of that nature. So on the one side you could freeze out the rates and on the other side let the managers take advantage of an increasing interest rate world if they were successful in managing it correctly.

Q. And what would be the result of their successful management, sir?

A. Well the result, if I locked in say, say through Banker's Acceptances you lock into a — let's use three years for example of the loan and I think this was a five year revolving, into a five year term. So say five years and if you locked into that and you locked in at one rate and it was very economical relative to what developed later on, then there is a good chance that the managers would be able in a higher interest rate environment to make good money for me.

Q. How would that translate for you, sir?

A. In extra profits.

Q. And how would that be, how would you cash in on the extra profits?

A. In the same way that I cashed in before. You get some of it in dividends and some of it in profits at the end.

Examination of Ludmer, transcript of July 5, 1990, pages 30-33.

99. Ludmer summed up his conclusions as follows:

Q. What gave you so much confidence in Justinian and Augustus?

A. Well, the confidence really came about from the management of the people who were involved to make the decisions with respect to the portfolio, namely Mr. Mead and the people from the Trust Corporation of the Bahamas.

Q. Except Mr. Mead, did you know any other people in those companies?

A. No, I didn't know the people of the Trust Corporation of the Bahamas, but the directors’ list is a very impressive list of business people.

Cross-examination of Ludmer, transcript of November 19, 1990, pages 194-98.

A. Yes, as I said before. One of the reasons, although far from the most important one that I invested in Justinian and Augustus, was I was getting the excellent management and there was also the advantage of the Panamanian lower tax rate, which again translates itself into more money available for the shareholders at either through dividends and over a combination of dividends and profit on disposable or redemption.

Cross-examination of Ludmer, transcript of November 19,1990, pages 208-09

100. These shares were purchased as long-term investments. That term was not defined and depended on the performance of the investments.

Examination of Ludmer, transcript of July 4, 1990, pages 211-12.

Cross-examination of Ludmer, transcript of November 22, 1990,pages 34-37.

Cross-examination of Ludmer, transcript of November 22, 1990, pages 40-43.

101. The decision to buy into Justinian and Augustus was made without the opinion of securities brokers or other persons.

Cross-examination of Ludmer, transcript of November 19, 1990, pages 187, 196-99.

Cross-examination of Ludmer, transcript of November 22, 1990, page 43.

Purchase of shares and their financing

(a) Brian, Cindy et David

(i) Justinian (No. 1)

102. On August 15, 1977, acting as the agent for Brian, Cindy and David, Ludmer subscribed 10,000 common shares of Justinian at the unit cost of $100 (U.S.) for a total consideration of $1,000,000 (U.S.), which subscription Justinian accepted on September 30, 1977.

Exhibit A-8(g), volume II, page 263.

Exhibit A-8(i), volume II, page 267.

Exhibit A-8(f), volume II, page 260.

Exhibit A-8(h), volume II, page 266.

Examination of Ludmer, transcript of July 4, 1990, pages 153-55, 157-58.

103. The purchase price of the shares of Justinian was paid by Brian, Cindy and David in the following manner:

(a) $200,000 from a distribution of the capital of the Ludmer Children Trust (hereinafter"the Trust"); and

(b) $873,768 from a loan granted by the Mercantile Bank of Canada (hereinafter "the bank”) to the trust, which in turn lent this sum to the children on the same conditions. This loan bore interest at the prime rate plus one per cent.

Exhibit A-8(e), volume II, page 257 et seq.

Exhibit A-33(a), volume VI, page 1111.

Exhibit A-33(b), volume VI, page 1114.

Exhibit A-33(c), volume VI, page 1118.

Examination of Ludmer, transcript of July 4, 1990, pages 156-59.

104. On October 17, 1977, Justinian confirmed the sale of the shares and forwarded the certificate (No. RA 00046) to the bank to be pledged as a guarantee for the loan granted by the latter.

Exhibit A-8(i), volume II, page 267.

Exhibit A-33(d), volume VI, page 1119.

(ii) Justinian No. 2

105. On June 16, 1978, acting as the agent for Brian, Cindy and David, Ludmer subscribed 10,000 common shares of Justinian at the unit cost of $101.55 (U.S.) for a total consideration of $1,000,000 (U.S.), which subscription Justinian accepted on July 3, 1978.

Exhibit A-9(a), volume II, page 268.

Exhibit A-9(b), volume II, page 275.

Exhibit A-9(c), volume II, page 274.

Exhibit A-9(d), volume II, page 275.

Exhibit A-9(e), volume II, page 276 et seq.

Examination of Ludmer, transcript of July 4, 1990, pages 168-69.

106. The purchase price of the shares was paid as follows:

(a) $340,000 out of a distribution of capital of the trust; and

(b) $801,232 out of a loan granted by the Bank to the trust, which in turn lent that sum to the children on the same conditions. This loan bore interest at the prime rate plus one per cent.

Exhibit A-33(e), volume VI, page 1125.

Exhibit A-33(f), volume VI, page 1127.

Exhibit A-33(g), volume VI, page 1128.

Examination of Ludmer, transcript of July 4, 1990, pages 171-77. Examination of Ludmer, transcript of July 5, 1990, pages 76-78. Exhibits R-21, R-38.

107. On July 18, 1978, Justinian confirmed the sale of the shares and forwarded the certificate (No. RA 00070) to the bank to be pledged as a guarantee of the loan granted by the latter.

Exhibit A-9(f), volume II, page 279.

(b) Ludco

(i) Augustus No. 7

108. On June 20, 1978, Ludco subscribed 10,000 common shares of Augustus at unit cost of $100 (U.S.), for a total consideration of $1,000,000 (U.S.). Augustus accepted this subscription on July 3, 1978.

Exhibit A-10(a), volume II, page 287 et seq.

Exhibit A-10(b), volume II, page 292 et seq.

Exhibit R-15.

109. The purchase price of these shares was paid as follows:

(a) $302,663 out of Ludco's available funds; and

(b) $830,000 out of a loan granted by the Bank which bore interest at the prime rate plus 1 [1] /2 per cent and A per cent if not for a fixed term, as the borrower chose.

Exhibit A-34(a), volume II, page 1129.

Exhibit A-34(b), volume II, page 1133.

Exhibit A-34(c), volume II, page 1134.

Examination of Ludmer, transcript of July 4, 1990, pages 177-78, pages 186-93. Examination of Ludmer, transcript of July 5, 1990, pages 74-76. Exhibit R-16, R-17.

110. On July 18, 1978, Augustus transmitted to the Bank two stock certificates (Nos. RA 00041 and RB 00006) for 6,000 class A shares and 4,000 class B shares respectively to be pledged as a guarantee of the loan granted.

Exhibit A-10(c), volume II, page 296.

Exhibit R-48.

(ii) Augustus No. 2

111. On December 20, 1978, Ludco subscribed 10,000 shares of Augustus for a total consideration of US$981,300 which Augustus accepted on December 29, 1978.

Exhibit A-11(a), volume II, page 298 et seq.

Exhibit A-11(c), volume II, page 305 et seq.

Examination of Ludmer, transcript of July 5, 1990, pages 51-52.

Exhibits R-1, R-12.

112. The purchase price of these shares was paid as follows:

(a) $213,574 out of a loan granted by the bank;

(b) $950,000 out of a loan granted by the bank;

(c) these loans bore interest at the prime rate plus A per cent (approximately Examination of Ludmer, transcript of July 5, 1990, pages 53-56. Exhibits R-2, R-19, R-20, R-22, R-24, R-25.

113. On January 22, 1979, Augustus advised Ludco that its certificates had been transmitted to the Bank to be pledged as aguarantee of the loan.

Exhibit A-11(c), volume II, page 305.

114. On October 1, 1980, the two loans that had been used to finance the purchase of Ludco’s shares in Augustus were consolidated and bore interest at the prime rate plus A per cent. The certificates for the 20,000 shares remained pledged.

Exhibits R-24 and R-25

115. On January 6, 1983, Ludmer confirmed the agreement reached with the bank to the effect that the interest rate on the consolidated loans was reduced to the prime rate plus /b per cent.

Exhibit R-26

(iii) Justinian No. 1

116. On June 23,1979, through Ludmer acting as its agent, Ludco subscribed 24,500 common shares of Justinian at the unit cost of $105.31 (U.S.), for a total consideration of $2,580,095 (U.S.) ($3,013,500 Cdn.), which subscription Justinian accepted on July 2, 1979.

Exhibit A-12(a), volume II, page 311 et seq.

Exhibit A-12(b), volume II, page 315.

Exhibit A-12(c), volume II, page 316.

Exhibit A-12(d), volume II, page 317.

Exhibit A-12(e), volume II, page 318.

Exhibit A-12(f), volume II, page 319.

Examination of Ludmer, transcript of July 5, 1990, pages 56-62.

117. The purchase price of those shares was paid out of a loan granted by the Excelsior Life Insurance Company (hereinafter" Excelsior"), which bore interest at the rate of 11.505 per cent which was guaranteed by mortgage. The purchase price was paid through the Bank of Montreal, which forwarded this payment to the Royal Bank and Trust Company of New York, U.S.A.

Exhibit A-12(b), volume II, page 324.

Exhibit A-12(e), volume II, page 318.

Exhibit A-12(g), volume II, page 322.

Exhibit A-35, volume VI, page 1150.

Paragraph 24(h) of the reply.

Examination of Ludmer, transcript of July 5,1990, pages 62-66.

118. On August 16, 1979, Justinian forwarded a stock certificate (No. RB 00009) for 24,500 class B common shares to Ludmer.

Exhibit A-12(i), volume II, page 326.

Exhibit A-12(j), volume II, page 328.

(iv) Subscription rejected

119. In December 1980, Ludco subscribed 10,000 shares of Augustus. Steps were taken to obtain a loan in the amount of $1,400,000 from the bank to finance the purchase price at an interest rate of 19 per cent.

Exhibits R-3, R-13, R-14.

120. The reasons which motivated Ludmer to make this new subscription were as follows:

Q. What was the interest rate, Sir, indicated in the debit memo?

A. In the debit memo?

Q. On the cheque too?

A. Nineteen per cent per annum.

Q. Weren't you afraid to borrow, I understand, 3.1 million at that time, at 19 per cent for shares that paid, until then, nominal dividends?

Me GUY DU PONT: Objection.

A. Well, I object to that too. First of all the dividends were not nominal.

Me GUY DU PONT : Thank you, Mr. Ludmer.

A. And I think, would you like me to practice? That statement of nominal dividends is an opinion, it is not a fact, so we’ll start with that. Number two is that I wasn't afraid to pay 19 per cent cause it's all a function of what you could earn, interest rates that you could earn at the time were very high as well.

Me DANIEL VERDON: So I understand that you were not afraid to borrow 3.1 million at nineteen per cent for the shares of Augustus?

A. Well, first of all we just saw that it was 1.4 million.

B. But the total of the proposed purchase with the loan that you already have. . . .

A. Was 3.1 million.

Q. Yes?

A. That's correct.

Q. So you had nineteen per cent?

A. Yes, but obviously, I mean unless you want to attribute to me that I’m nuts, which some people have said before, so you won't be the first, but if I’m going in to borrow an additional 1.4 million and I already have 1.7 million and the rates are high, it must mean that we're earning very good money on the other side. You can't make money by losing money.

Q. So I understand that you were not afraid to borrow, at nineteen per cent, 3.1 million?

A. That's correct, I was not.

Q. That's your answer, thank you, Sir?

A. Yes, I'm not afraid.

Q. What made you so confident that you could make a substantial profit?

A. Well, because I believed that I had three years history at this point and I believed that they were able to make a better profit than what the cost of money was.

[Emphasis added.]

Cross-examination of Ludmer, transcript of November 20, 1990, pages 31-33.

121. This subscription was rejected without Ludmer knowing the reasons.

Cross-examination of Ludmer, transcript of November 22, 1990, pages 25-28

v. Summary

122. The shares purchased by the appellants at the relevant time were thus allotted as follows:

Beneficiary	Number of	Class	Certificate
	shares		number
JUSTINIAN
Brian, Cindy & David	10,000	A	RA 00070
Brian, Cindy & David	5,000	B	RB 00015
Brian, Cindy & David	1,000	A	RA 1007
Brian, Cindy & David	4,000	B	RB 00019
Ludco	24,500	B	RB 00009
AUGUSTUS
Ludco	6,000	A	RA 126
Ludco	14,000	B	RB 00014

YIELD OF SHARES

(1) Dividends

123. During the relevant period, the appellants and 2154 received from Justinian and Augustus dividends of US$1 per share, which they included in computing their income and which were assessed by the respondent.

(a) Justinian

Exhibits A-31(a) to A-31(e), Volume VI, pages 1071-88.

(b) Augustus

Exhibits A-32(a) to A-32(h), Volume VI, pages 1089-10.

Examination of Ludmer, transcript of July 5, 1990, pages 84-88. Cross- examination of F.T., transcript of May 8, 1990, page 152.

124. The dividends which the appellants and 2154 received totalled as follows:

LUDCO	Augustus	Justinian	TOTAL
1978	—	—
1979	$ 11,734	—	$ 11,734
1980	23,338	$ 28,589	51,927
1981	24,038	29,446	53,484
1982	23,728	29,216	52,944
1983	24,818	30,341	55,159
	$107,656	$117,592	$225,248
2154
1984	$24,884	$30,549	$ 55,433
1985	26,334	32,308	58,642
	$51,218	$62,857	$114,075
BRIAN
1979	—	$ 8,591	—
1980	—	7,793	—
1981	—	7,950	—
1982	—	8,256	—
1983	—	8,313	—
1984	—	8,313	—
1985	—	9,233
	—	$58,449	$58,449
CINDY
1979		$ 8,591	—
1980	—	7,793	—
1981	—	7,950	—
1982	—	8,256	—
1983	—	8,313	—
1984	—	8,313	—
1985	—	9,233	—
	—	$58,499 [sic]	$58,449
DAVID
1979	—	$ 8,591	—
1980	—	7,793	—
1981	—	7,950	—
1982	—	8,256	—
1983	—	8,313	—
1984	—	8,313	—
1985	—	9,233	—
		$58,449	$ 58,449
			$175,347
	GRAND		$514,670
	TOTAL:

Exhibit A-60, volume VII, page 1306.

Exhibit A-61, volume VII, page 1307.

Exhibit A-99, volume IX, page 1793.

Exhibit A-100, volume IX, page 1809.

Examination of Ludmer, transcript of July 5,

1990, page 110.

(2) Value of shares

125. The financial statements of Justinian and Augustus attested to, inter alia, fluctuations in the value of the shares of those two companies:

(a) Justinian

Exhibit A-20(a) Exhibit A-20(bj), volume II, page 386 to volume IV page 689 (monthly).

Exhibit A-13 to Exhibit A-15, volume II, pages 331-53 (annual).

(b) Augustus

Exhibit A-21(a) volume IV, page 690 to volume V, page 1020 (monthly). Exhibit A-16, volume II, pages 354-85 (annual).

126. During the relevant period, the statements listed in Exhibits A-20 and A-21 attributed to the shares of Justinian and Augustus values which fluctuated from $98.71 (October 3, 1977) to $174.86 (October 31, 1984) for Justinian and $98.13 (December 31, 1978) to $172.99 (October 31, 1984) for Augustus.

(3) Reports and financial statements

127. The appellants received copies of reports sent by the Altanational managers to T.C.B. reflecting the investment policies that were recommended by Altanational and followed by T.C.B. for Justinian and Augustus, as well as tables providing a comparative study of yields. These reports attested to the investment policies which the managers of Justinian and Augustus intended to follow and to the risks inherent in their policy.

Exhibit A-22, Volume V, page 1021.

Exhibit A-23, Volume V, page 1026.

Exhibit A-24(a), Volume V, page 1031.

Exhibit A-24(b), Volume V, page 1032.

128. Following their purchase, the appellants received regular reports from Justinian and Augustus attesting to their respective financial situations and fluctuations in their respective portfolios. The monthly reports included financial statements attesting to each investment, and the annual reports presented the results of the annual [sic] fiscal year of Justinian or Augustus.

(a) Justinian

Exhibit A-20(a) Exhibit A-20(bj), volume II, page 386 to volume IV page 689 (monthly).

Exhibit A-13 to Exhibit A-15, volume II, pages 331-53 (annual).

(b) Augustus

Exhibit A-21 (a) volume IV, page 690 to volume V, page 1020 (monthly).

Exhibit A-16, Volume II, pages 354-85 (annual).

129. The reports and statements obtained from Justinian and Augustus were read and analyzed from time to time by Ludmer in order to monitor the performance of these companies.

Examination of Ludmer, transcript of July 5, 1990, pages 33-34, 42-44.

130. The performance of the Justinian and Augustus portfolio compared favourably with other investment companies specialized in bonds.

Examination of Ludmer, transcript of July 5, 1990, pages 128-29. Exhibit A-24(a), volume V, page 1031.

Are the reassessments invalid?

4.04.1 In his argument outline, counsel for the appellants presented the two basic submissions as follows, at paragraphs 4 and 5:

4. The appellants also claim that the reassessments under appeal are null and void and that the respondent was precluded from issuing them because:

(a) from 1979 to 1981, the appellants were subjected to a careful and thorough investigation by the respondent mainly concerning the question of the deductibility of the interest incurred on the loans used to purchase their shares in Justinian and Augustus;

(b) the respondent acknowledged that these interest expenses were eligible and allowed the deductions claimed, in accordance with the I.T.A. and with its administrative policy concerning the deductibility of interest;

(c) the respondent could not, when the appellants were right in believing that this question had been resolved and had planned their affairs accordingly, fairly issue reassessments in 1986 and 1987, retroactive to the taxation years 1981 to 1985, disallowing the interest expenses claimed and could not arbitrarily and retroactively revoke its policy under which the interest expenses incurred on loans used to purchase shares were deductible.

5. The appellants claim, lastly, that the reassessments under appeal are null and void because:

(a) the respondent could not, in the guise of disputing the deductibility of the interest, try to solve the "problem" which he perceived at the time, that is the taxation of the income generated by these so-called "offshore" companies, a "question" which was in fact settled by legislative amendment, that is the adoption of section 94.1 I.T.A. , which was put into effect in 1986 by S.C. 1984, chapter 45, section 30 and S.C. 1985, chapter 45, section 148;

(b) the respondent could not usurp Parliaments legislative function by trying to sanction proposals which did not have force of law and to which Parliament, in its wisdom, had not deemed wise to give effect during the relevant period;

(c) the respondent could not, in an arbitrary and discriminatory manner, select the appellants, as investors of Justinian and Augustus, as targets for the purpose of disallowing their interest expenses, when it authorized every other taxpayer investing in companies to deduct his interest expenses;

(d) the respondent could not, in an arbitrary and discriminatory manner, select the appellants as the sole target of a full-scale investigation and of reassessments the purpose of which was to disallow the deductions claimed, when many other taxpayers who had invested in similar companies were not disturbed on this matter; and

(e) the respondent could not allow the application of paragraph 20(1)(c) to be contingent on the pure and simple arbitrariness of the public servant responsible for the file by not providing that officer with any standard of assessment, except a vague and imprecise concept of “nominal dividend”, which was nowhere defined, either in the I.T.A. or in the respondents directives.

5. Arguments of the parties

5.01.1 A number of statutory provisions of the Act were referred to by the parties concerning the deductibility of interest, that is paragraph 20(1)(c) and subsections 9(3), 245(1) and 248(1).

5.01.2 These provisions read as follows at the relevant period:

(A) Paragraph 20(1 )(c)

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 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 (other than borrowed money used to acquire property the income from which would be exempt or to acquire a life insurance policy), or a reasonable amount in respect thereof, whichever is the lesser;

(B) Subsection 9(3)

This subsection then defined the expression income from a property":

9.(3) In this Act, “income from a property" does not include any capital gain from the disposition of that property and “loss from a property" does not include any capital loss from the disposition of that property.

Subsection 9(3) was amended for the taxation years ended after August 30, 1983 by S.C. 1983-84, chapter 1, section 4, to read as follows:

9.(3) In this Act,"income from a property" does not include any amount that is, or that would but for subparagraph 39(1)(a)(v) be, a capital gain from the disposition of that property or any amount that is a capital gain (within the meaning assigned by paragraph 47.1 (1 )(b)) from an indexed security investment plan and "loss from a property" does not include any amount that is, or that would but for subparagraph 39(1)(a)(v) be, a capital loss from the disposition of that property or any amount that is a capital loss (within the meaning assigned by paragraph 47.1 (1 )(c)) from an indexed security investment plan.

(C) Subsection 245(1)

245.(1) Artificial transactions. In computing income for the purposes of this Act, no deduction may be made in respect of a disbursement or expense made or incurred in respect of a transaction or operation that, if allowed, would unduly or artificially reduce the income.

(D) Subsection 248(1)

Subsection 248(1) defined the expression "exempt income" as follows:

"exempt income” means money or property received or acquired by a person in such circumstances that it is, by reason of any provision in Part I, not included in computing his income, but for greater certainty does not include a dividend on a share, except that, for the purposes of paragraph 247(1)(c), “exempt income” includes a dividend received by him the amount of which may be deducted by him from his income by virtue of subsection 112(1);

At the relevant time, subsection 248(1) of the Income Tax Act defined the expression "property" as follows:

"property" means property of any kind whatever whether real or personal or corporeal or incorporeal and, without restricting the generality of the foregoing, includes

(a) a right of any kind whatever, a share or a chose in action,

(b) unless a contrary intention is evident, money,

(c) a timber resource property;

This definition was amended to add the following paragraph for the taxation years 1987 and following:

(d) the work in progress of a business that is a profession;

5.02 Appellants’ argument on paragraph 20(1 )(c)

5.02.1 The appellants emphasized, first, that the prerequisite conditions of interest deductibility for the purposes of the instant appeals were as follows:

(a) the interest must be payable pursuant to a legal obligation to pay interest;

(b) the money borrowed must be used for an eligible purpose, that is in order to earn income from a business or property;

(c) the money borrowed must be used directly and currently for an eligible purpose; and

(d) the amount paid as interest must be reasonable.

5.02.2 The appellants submitted that the uncontroverted and undisputed evidence clearly established that, considering the economic reality of the transactions, the interest expenses which they claiemd and deducted met all the prerequisite conditions under paragraph 20(1 )(c) of the Act.

5.02.2(1) Legal obligation and payment

The legal obligation to pay interest and the actual payment of the said interest are not points at issue.

5.02.2(2) Eligible use

5.02.2(2.1) The appellants first referred to Bronfman Trust to establish the basic principle and then to a series of other cases in which the courts determined that interest paid on borrowed money which had been used to purchase shares was deductible.

5.02.2(2.2) I cite the argument outline:

210. In addressing each of these prerequisite conditions, it is important to recall the following principle established by Dickson, C.J. in Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32, [1987] 1 C.T.C. 117, 87 D.T.C. 5059, to the effect that the economic reality of the transactions carried out should be considered in determining whether the money is used for the purpose of earning income from a business or property [at page 52 (C.T.C. 128; D.T.C. 5066-67)]:

I acknowledge, however, that just as there has been a recent trend away from strict construction of taxation statutes (see Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536, [1984] C.T.C. 294, 84 D.T.C. 6305, at pages 573-79 (C.T.C. 313-16; D.T.C. 6321-24), and The Queen v. Golden, [1986] 1 S.C.R. 209 [1986] 1 C.T.C. 274, 86 D.T.C. 6138, at pages 214-15 (C.T.C. 277; D.T.C. 6140)), so too has the recent trend in tax cases been towards attempting to ascertain the true commercial and practical nature of the taxpayer's transactions.

212. In Bronfman Trust v. The Queen, supra, Dickson, C.J. emphasized that, under paragraph 20(1 )(c) I.T.A., the borrowed money must have been used for the purpose of earning income from a business or property, which requires a determination of the purpose of the use of borrowed money [at page 46 (C.T.C. 125; D.T.C. 5064)]:

The interest deduction provision requires not only a characterization of the use of borrowed funds, but also a characterization of” "purpose". Eligibility for the deduction is contingent on the use of borrowed money for the purpose of earning income. It is well-established in the jurisprudence, however, that it is not the purpose of the borrowing itself which is relevant. What is relevant, rather, is the taxpayer's purpose in using the borrowed money in a particular manner: Auld v. M.N.R. (1962), 28 Tax A.B.C. 236, 62 D.T.C. 27. Consequently, the focus of the inquiry must be centered on the use to which the taxpayer put the borrowed funds.

213. The application of paragraph 20(1)(c) I.T.A. (or of its predecessor paragraph 11(1)(c)) to cases in which borrowed funds were used to purchase shares has formed the subject of a number of decisions. In Auld v. M.N.R., supra, Commissioner Boland wrote [at page 244 (D.T.C. 31)]:

This leads me to a consideration of the additional words "or property" which provides an alternative test. If the borrowed money is used for the purpose of earning income from property, the requirements of the section are satisfied. The property in this case, so far as the appellant is concerned, is his shares and the income therefrom would be dividends. In the Canada Safeway appeal ([1957] S.C.R. 717, [1957] C.T.C. 335, 57 D.T.C. 1239), the taxpayer was a corporation and the dividends it might receive would be exempt income. Of course as the appellant here is an individual and the dividends are not exempt in his hands, that portion of the judgment is not applicable. I have come to the conclusion that $7,500 of the borrowed money was used by the appellant for the purpose of earning income from property to the extent of the interest on that amount the requirements of paragraph 11 (1)(c) are met and the interest is deductible.

214. In Moore v. M.N.R., [1971] Tax A.B.C. 817, 71 D.T.C. 543, Commissioner Weldon found that the interest on loans used to purchase shares in mining companies was deductible where those shares paid dividends.

215. In Haig v. M.N.R., [1972] C.T.C. 2562, 72 D.T.C. 1465 (T.R.B.), Chairman Flanigan expressly recognized that a taxpayer who purchased shares for the purpose of earning income in the form of dividends was entitled to deduct his interest expenses, even if he also hoped to realize a profit on the sale of his shares:

The witness quite frankly admits that he purchased the shares for two reasons. One was that, based on the orders that were coming in, the company was apparently going to start to realize the expectations that were predicted in the feasibility study, and it could be seen that, after a disastrous start, the company was going to begin to generate good returns on its money. Therefore appellant's first hope was that the share value would appreciate and increase, and his second was that the company would declare a dividend and he would thus benefit from both aspects.

The parties have not been able to cite any case in point that would assist the Board in arriving at a decision in this case. I am reminded of certain statements made in the case of Irrigation Industries Ltd. v. M.N.R., [1962] S.C.R. 346, [1962] C.T.C. 215, 62 D.T.C. 1131. The reasons leading to the conclusions of Cameron, J. in what was then the Exchequer Court of Canada are referred to by Martland, J. of the Supreme Court of Canada as follows at page 350 (C.T.C. 218; D.T.C. 1132):

The reasons leading to his (Mr. Justice Cameron's) conclusions that the purchase was not an investment are:

1. The fact that the appellant borrowed the funds necessary to effect the purchase of the shares;

2. The inference that the nature of Brunswick indicated that its shares were speculative in value and that dividends could not be expected for some years.

Martland, J. then goes on to Say at:

With respect, I would not think that the question of whether securities are purchased with the purchaser’s own funds, or with money borrowed by him, is a significant factor in determining whether their purchase and subsequent sale is or is not an investment.

Similarly, the fact that there was no immediate likelihood of dividends being paid on the shares should not have much significance, for there are many corporate ventures, financed by the sale of shares to the public, in which immediate payment of dividends, may not be anticipated, and yet the purchase of the treasury shares of a company embarking on a new enterprise is a well recognized method of making an investment.

And later:

It is difficult to conceive of any case, in which securities are purchased, in which the purchaser does not have at least some intention of disposing of them if their value appreciates to the point where their sale appears to be financially desirable. If this is so, then any purchase and sale of securities must constitute an adventure in the nature of trade, unless it is attempted to ascertain whether the primary intention at the time of purchase is to retain the security or to sell it. This however, leads to the difficulty mentioned by my brother Cartwright that the question of taxability is to be determined by seeking to ascertain the primary subjective intention of the purchaser at the time of purchase, [pages 2569-76 (D.T.C. 1471-76)]

[Emphasis added.]

Counsel for the appellants also referred to Thomas v. M.N.R., [1977] C.T.C. 2227, 77 D.T.C. 171 (T.R.B.), Lafortune v. M.N.R., [1979] C.T.C. 2087, 79 D.T.C. 126 (T.R.B.), Harrand v. M.N.R., [1987] 1 C.T.C. 2026, 86 D.T.C. 1855 (T.C.C.), Mandryk v. Canada, [1989] 1 C.T.C. 162, 89 D.T.C. 5062 (F.C.T.D.), Emerson v. The Queen, [1985] 1 C.T.C. 324, 85 D.T.C. 5236 (F.C.T.D.); aff'd by [1986] 1 C.T.C. 422, 86 D.T.C. 6184 (F.C.A.), in which the courts affirmed the principle that the interest paid on sums borrowed for the purpose of purchasing shares were deductible.

5.02.2(2.3) Counsel for the appellants therefore argued as follows:

219. The un controverted and undisputed evidence clearly shows that the appellants purchased their shares in Justinian and Augustus for the purpose, inter alia, of earning income in the form of dividends and that the appellants in fact received dividends on their shares during those taxation years in which they deducted their interest expenses.

220. The purchase of shares for the purpose of earning income in the form of dividends (and a capital gain on disposition) constitutes one of the traditional forms of investment, and a loan for the purpose of financing such purchases is a loan used for the purpose of earning income (Vide the notes of Martland, J. cited by Flanigan, J. in Haig v. M.N.R., supra).

[Translation.]

5.02.2(2.4) In his argument outline, counsel for the appellants referred to the cross-examination of Mr. Franco Tirabasso, an accountant with Revenue Canada. Mr. Tirabasso admitted that there was no difference in principle between the appellants’ investment and an investment in a company such as Bell Canada.

Furthermore, the appellant also admitted that Revenue Canada allowed the interest deduction even if there were no dividends:

Q. What's the difference here, sir?

A. The difference in this situation is the offshore element, I would assume.

Q. And to your knowledge, sir, that's the only difference?

A. From what you've told me, keeping in mind the amount of dividends, 1 would compare this to a Bell Canada kind of thing.

Q. And what would be the result if this were a Bell Canada kind of thing, sir?

A. Well, the difference is that if you invest in Bell Canada dividends are paid; they're not accumulated, and I think here they were accumulated — there is no — I'm sorry, there is really no difference.

Q. There is really no difference.

The only thing which is of any significance is the fact that these corporations were Offshore. Is that your testimony, Mr. Tirabasso?

A. That's one of the elements. I can't see any other ones right now.

Q. There are no other ones. Is that not fair, sir?

A. There is also maybe a question of control of the offshore funds which I would look into.

Q. Were there any other elements, sir?

A. That would be it.

Q. So the fact that these corporations were offshore is the only significant difference between that and a situation where an investor would buy into Bell Canada shares?

A. Yes.

Q. And would the same apply for all three children and the company, sir, for all taxation years in issue?

A. Yes.

Q. And then do I take it, sir, that in those circumstances — if these were Bell Canada shares — Revenue Canada would have allowed my clients to pay the interest expense in full?

A. Again, as you stated before, if we invest in shares similar to Bell Canada, we would have allowed the interest expense.

Q. Even though there would have been a low yield?

A. Normally most public companies have low yield.

Q. That's not my question to you, sir. Even if there were a low yield.

A. Yes.

Q Revenue Canada would allow the interest expense?

A. Yes.

Q. And is it not fair to say, sir, having regard to the policy that we have seen in the hotline questions, that Revenue Canada would allow the interest expense even if there were no dividends?

A. According to the hotline, there was a specific question said no dividends, that's correct.

Q. So that the appellants or the taxpayers here would be allowed to claim the full interest expense?

A. Yes.

[Translation.]

Cross-examination of Tirabasso, transcript of May 8, 1991, pages 155-61.

5.02.2(2.5) Mr. Herbert Gutenplan, a chartered accountant and auditor employed by Revenue Canada since 1964, was head of Tax Avoidance headquarters in Montréal from 1976 to 1982. He had investigated the Justinian and Augustus funds, inter alia. According to counsel for the respondent, he provided the basis of the presumptions of fact on which the respondent in large part relied in his reply to the notice of appeal (transcript of May 6, 1991, pages 127-30).

Mr. Gutenplan made the same admissions as those of Mr. Tirabasso described at the preceding paragraph:

The only differences were that the shareholder of Justinian and Augustus did not receive the benefit of the gross-up in respect of the dividend tax credit and that Justinian and Augustus were not subject to Canadian tax, like any other company doing business and resident abroad.

[Translation.]

Cross-examination of Gutenplan, transcript of May 7, 1991, pages 96-98.

The same was also true of Mr. John Alexander Calderwood in cross- examination (transcript of May 7, 1991, pages 263-266). Mr. Calderwood was an officer of Revenue Canada at headquarters in Ottawa. More precisely, he was Director, Audit Review Division, and also Acting Director, Tax Avoidance Program. In 1983, he became Director, Tax Avoidance Division.

5.02.2(2.6) Following these representations, counsel for the appellants submitted that the latters' loans had been used to gain and produce income.

5.02.2(3) Direct and current use

5.02.2(3.1) Counsel for the respondent submitted the following argument:

224. The appellants claim that, at all times relevant to the instant appeals, they directly and currently used the borrowed funds for an eligible purpose, that is to purchase shares in Justinian and Augustus, and that the roll-over that occurred in 1983 in no way affected this conclusion since, following that roll-over, Ludco simply substituted interest-bearing promissory notes of [its subsidiary] 2154 and dividend-paying preferred shares of 2154 for the shares which it held in Justinian and Augustus.

225. Numerous judgments illustrate the principle that there may be a number of successive eligible uses of borrowed funds under paragraph 20(1 )(c) I.T.A. and that the current use of the borrowed funds is the sole relevant use.

[Translation.]

Bronfman Trust, in which Dickson, C.J. affirmed that there could be a number of successive eligible uses of borrowed funds, was cited [at page 47 (C.T.C. 125; D.T.C .5064-65)]:

The cases are consistent with the proposition that it is the current use rather than the original use of borrowed funds by the taxpayer which is relevant in assessing deductibility of interest payments: see, for example, Lakeview Gardens Corp. v. M.N.R., [1973] C.T.C. 586, 73 D.T.C. 5437 (F.C.T.D.), per Walsh, J., for a correct application of this principle. A taxpayer cannot continue to deduct interest payments merely because the original use of borrowed money was to purchase income-bearing assets, after he or she has sold those assets and put the proceeds of sale to an ineligible use. To permit the taxpayer to do so would result in the borrowing of funds to finance the purchase of income-earning property which could be resold immediately without affecting the deductibility of interest payments for an indefinite period thereafter.

Conversely, a taxpayer who uses or intends to use borrowed money for an ineligible purpose, but later uses the funds to earn non-exempt income from a business or property, ought not to be deprived of the deduction for the current, eligible use: Sinha v. M.N.R., [1981] C.T.C. 2599, 81 D.T.C. 465 (T.R.B.); Attaie v. M.N.R., [1985] 2 C.T.C. 2331, 85 D.T.C. 613 (T.C.C.) (presently under appeal). For example, if a taxpayer borrows to buy personal property which he or she subsequently sells, the interest payments will become prospectively deductible if the proceeds of sale are used to purchase eligible income-earning property.

In addition, Commissioner Boland wrote in Auld v. M.N.R. (1962), 28 Tax A.B.C. 236, 62 D.T.C. 27, at page 240 (D.T.C. 30):

In my opinion, it is not the purpose underlying the borrowing of the money which is relevant; it is the purpose underlying the use of the borrowed money.

The following judgments were also cited or referred to:

Trans-Prairie Pipelines Ltd. v. M.N.R., [1970] C.T.C. 537, 70 D.T.C. 6351 (Exch. Ct.), page 541 (D.T.C. 6353-54);

Lakeview Gardens Corp. v. M.N.R., [1973] C.T.C. 586, 73 D.T.C. 5437 (F.C.T.D.), page 594 (D.T.C. 5442);

Anglemont Estates Ltd. v. M.N.R., [1989] 1 C.T.C. 2004, 88 D.T.C. 1770 (T.C.C.);

Botkin v. M.N.R., [1989] 2 C.T.C. 2110, 89 D.T.C. 398 (T.C.C.);

Sinha v. M.N.R., [1981] C.T.C. 2599, 81 D.T.C. 465 (T.R.B.), page 2601 (D.T.C. 467)

5.02.2(3.2) Counsel for the appellants then made the following submissions:

231. For economic and commercial reasons, Ludco deemed it useful to shelter its assets other than real estate from possible financial difficulties that might result from its development projects to be undertaken with Ivanhoé Inc.

232. For this purpose, Ludco assigned to its subsidiary 2154, by means of a tax rollover, inter alia, its securities, including those in Justinian and Augustus, in exchange for 194 preferred shares of 2154 and promissory notes, some of which bore interest.

233. The appellants claim that, as a result of the rollover of Ludco’s shares in 2154, Ludco became the holder of interest-bearing promissory notes issued by that subsidiary and of dividend-bearing preferred shares.

234. The appellants claim that, since the rollover, Ludco has substituted for the shares which it held in Justinian and Augustus the promissory notes and shares of 2154 which produced income in the first case in the form of interest, and in the second case, in the form of preferred dividends. [5]

235. It follows, in the appellants’ view, that, in applying the test of direct and current use developed in Bronfman Trust, supra, and having regard to the commercial reality of the transactions involved, Ludco was entitled to claim the deduction of its interest expenses after the date of the rollover.

[Translation.]

5.02.2(4) Reasonable amount

Counsel for the appellants made the following submissions:

236. It should be noted, first, that there is nothing in paragraph 20(1)(c) I.T.A. which in any way whatever requires that a correlation be made between the interest expense and the income actually earned from the property or business. The test of paragraph 20(1)(c) I.T.A. is that the borrowed money must be used for the purpose of earning income from a business or property (vide Auld v. M.N.R., supra; Haig v. M.N.R., supra; Harrand v. M.N.R., supra; and Moore v. M.N.R., supra) and there is nothing in that paragraph which restricts the interest expense to the business or property income actually produced. [6]

237. In Distillers Corporation Seagrams Ltd. v. M.N.R., [1958] C.T.C. 305, 58 D.T.C. 1168, Thurlow, J., as he then was, found that the expression “for the purpose of” used in the former paragraphs 12(1)(a) and 12(1)(c) of the Income Tax Act, S.C. 1952, chapter 148, referred to the purpose of the expense incurred, not to its result [at page 312 (D.T.C. 1172)]:

[Translation.]

Under both sections 12(1)(a) and 12(1 )(c) the limitation imposed on the deductibility of an expense is determined by the purpose for which it was incurred, rather than by the result. Nor is the deductibility or non-deductibility of an expense dependent on its having produced or not produced or even been calculated or likely to produce income. In my opinion, the extent to which these expenses may reasonably be regarded as having been incurred for the purpose of gaining dividend income cannot be resolved by reference to the appellant's income receipts, but I think it can be resolved in a rough way by consideration of how income was to be produced from the appellant’s business. The appellant's capital was invested in shares and in loans to subsidiary companies and was thus employed for the purpose of gaining or producing income in the form of dividends and interest. The means of obtaining the income was that of holding the investments and receiving the income as it accrued. The expenses in question were incurred generally for the same purpose and in the same pursuit.

238. In No. 695 v. M.N.R. (1960), 24 Tax A.B.C. 92, 60 D.T.C. 195, Commissioner Boisvert wrote:

The "purpose" is to be distinguished from the "facts". Purpose is defined:

. . . that which one sets before him to accomplish; an end, intention or aim, object, plan, project (Black's Law Dictionary).

And, in view of the wording of paragraph 11(1)(c), supra, as long as the "purpose" is established, the result is of no importance. [page 96 (D.T.C. 198)]

239. The appellants further claim that the words “reasonable amount” in paragraph 20(1 )(c) in fine concern the reasonableness of the determined interest paid by comparing that interest on the loans to the interest currently payable on the market, not by comparing it to the income actually earned from the property or from the business.

240. In Alberta and Southern Gas Co. v. The Queen, [1976] C.T.C. 639, 76 D.T.C. 6362 (F.C.T.D.) [aff'd [1977] C.T.C. 388, 77 D.T.C. 5244 (F.C.A.) and [1979] 1 S.C.R. 36, [1978] C.T.C. 780, 78 D.T.C. 6566], a company claimed the deduction for interest paid on funds borrowed and used to execute a contract entitling it, inter alia, to receive interest of three per cent on those funds. Cattanach J. found that the interest was deductible, even if it exceeded the income earned from the property. He emphasized that paragraph 20(1)(c) I.T.A. required that an income be earned from a property, not that a profit be earned on a property [C.T.C. 653 (D.T.C. 6371)]:

The plaintiff did receive income from the transactions and accordingly the interest was paid on borrowed money used for the purpose of earning income from property. Income arose from the three per cent interest rate negotiated by the plaintiff and Amoco on the consideration paid by the plaintiff to Amoco. It is true that the interest rate on the money borrowed from its bank by the plaintiff exceeded the rate that the plaintiff received from Amoco but that does not detract from the fact that the interest the plaintiff received from Amoco was income. As I recall the bank loan was paid by the plaintiff with expedition and the indebtedness of Amoco ran for a year which may have resulted in a profit to the plaintiff. Profit is different from income. Profit is the income less the cost laid out to earn the income. Therefore the interest paid to the plaintiff remains income even if no profit resulted.

241. In M.N.R. v. Mid-West Abrasive Co. of Canada Ltd. ,[1973] C.T.C. 548, 73 D.T.C. 5428 (F.C.T.D.), Sweet, D.J., en obiter, applied the test of reasonableness stated in paragraph 20(1 )(c) I.T.A. in fine, by comparing the interest paid to [sic] the borrowed funds, which was tantamount to considering the rate of interest paid on the loan [page 558 (D.T.C. 5436)]:

Although it is not necessary in this case to have regard to the provision in section 11 which, in any event, has the effect of prohibiting any deduction for interest beyond a reasonable amount, it is of some interest to note that if the sum of $46,512.30 were interest only in respect of the year ended June 30, 1967 that amount together with the interest item of $6,692.04 not in issue would total $53,204.35. That, if it were applicable only to the 1967 taxation year would be an inordinate amount of interest for one year on the total of the money the respondent borrowed from its parent company ($210,000 — see section 4 of agreed statement of facts).

242. The effect of assessing the reasonableness of the amount of interest paid by comparing it to the amount of the dividend received would be to make deductibility of the interest contingent on the percentage to which the investment is financed through borrowing. Annual interest of $100 paid on a loan of $1,000 used to purchase shares worth $10,000 and bearing an annual dividend of $100 would thus be more “ reasonable” than annual interest of $200 paid on a loan of $2,000 used to make the same investment, that is in shares worth $10,000 bearing a dividend of $100. The question should therefore be: starting from what percentage of financing would interest cease to be deductible, 20 per cent, 50 per cent, 75 per cent?

243. The appellants claimed that Parliament could not have wished such a result and that the reasonableness of interest must be assessed solely on the basis of the rate of interest payable in the market during the period in issue.

244. It has been shown that the appellants paid the Bank interest at the prime rate plus one per cent (in round numbers) and a fixed rate (11.505 per cent) to Excelsior. On the other hand, the evidence shows that the average rates of average dividend yield [sic] of public companies at the time was three per cent.

245. Having regard to these facts, the respondent cannot seriously claim that the amounts of interest paid were not reasonable. As Martland, J. emphasized in Irrigation Industries Ltd. v. M.N.R., [1962] S.C.R. 346, [1962] C.T.C. 215, 62 D.T.C. 1131, in which he wrote at page 350 (C.T.C. 218-19, D.T.C. 1132-33):

With respect, I would not think that the question of whether securities are purchased with the purchaser's own funds, or with money borrowed by him, is a significant factor in determining whether their purchase and subsequent sale is or is not an investment.

Similarly, the fact that there was no immediate likelihood of dividends being paid on the shares should not have much significance, for there are many corporate ventures, financed by the sale of shares to the public, in which immediate payment of dividends, may not be anticipated, and yet the purchase of the treasury shares of a company embarking on a new enterprise is a well recognized method of making an investment.

Further:

It is difficult to conceive of any case, in which securities are purchased, in which the purchaser does not have at least some intention of disposing of them if their value appreciates to the point where their sale appears to be financially desirable. If this is so, then any purchase and sale of securities must constitute an adventure in the nature of trade, unless it is attempted to ascertain whether the primary intention at the time of purchase is to retain the security or to sell it. This however, leads to the difficulty mentioned by my brother Cartwright that the question of taxability is to be determined by seeking to ascertain the primary subjective intention of the purchaser at the time of purchase.

[Emphasis added.]

246. Supposing that the interest paid must be compared to the dividend received in order to determine the reasonableness of the interest, which is denied, both the interest paid by the appellants and the dividends which they received were consistent with the rates currently applicable in the market, and the interest expenses were accordingly reasonable.

5.03 Respondent's theory seen by the appellants

The respondent's theory of the so-called token dividend, seen by the appellants based on the facts assumed by the respondent in the replies to the notices of appeal, is summarized below, followed by the principal testimony on the subject, at paragraphs 247 to 275 of the appellants’ argument outline:

247. The respondent's theory, as the appellants understand it, is based on the conclusion that the appellants did not purchase these shares for the purpose of earning income, but solely in order to realize a "capital gain” because the pre-set policy of Justinian and Augustus was that they would pay only a token dividend, as witness the following presumptions of fact alleged in the reply:

[Translation.]

(l) The investment policy of Justinian was to pay nominal dividends and to reinvest earnings for capital appreciation of its shares; (denied)

(m) The established dividend policy of Justinian was to pay only $1 per share; (denied)

(n) The appellant who borrowed funds to make his investment knew that, based on the dividend policy of Justinian, the interest expense would create losses for income tax;” (denied)

Subparagraphs 16 (I), (m) and (n) of David’s reply. [7]

248. The appellants claim that the respondent's thesis has no foundation either in the evidence or in the law.

249. There is no evidence that establishes or tends to establish:

(a) that the dividend payment policy of Justinian and Augustus was pre-set;

(b) that that policy was to pay a so-called "token" dividend; and

(c) that the appellants purchased those shares knowing that the policy of Justinian and Augustus was to pay a token dividend.

250. Furthermore, the appellants claim that the respondent cannot seriously argue that subsection 9(3) I.T.A., which excludes capital gains from the definition of “income from property”, can apply (for the purposes of paragraph 20(1)(c) I.T.A.) to an income-producing property, such as shares, which the taxpayer purchased for investment purposes.

251. Such an interpretation would restrict interest deductibility solely to property purchased for speculative or commercial purposes and would go directly against the purpose of paragraph 20(1)(c) I.T.A., that is the accumulation of incomeproducing capital.

(a) Token dividends

252. Ludmer testified under oath that the appellants had never received any representation whatever concerning the existence of a pre-set dividend payment policy, and such a policy, if it had existed, would have constituted an important material fact which Justinian and Augustus should have disclosed in their respective prospectuses:

[Translation.]

Q. Were you aware of any preset policy by the board of directors of this company vis-à-vis dividends, Mr. Ludmer?

A. No, I was not.

Q. Were you aware of any policy to the effect that the corporation would pay only a nominal dividend or a tokendividend?

A. No, I was not.

Q. Did you ever receive any said representations from any person associated with the company?

A. No, I never did.

Q. So when you bought into this company, sir, in 1977, you were not aware of any such policy in connection with dividends?

A. No, I wasn't and in fact I believed that if there was such a policy, then it would have to have been disclosed in the confidential explanatory memorandum as a

Q. Why?

A. Well, because I believe it would have been a very material fact which couldn't be omitted from

Q. Why?

A. Why?

Q. Why?

A. Well, why, because if somebody is saying to you that we are going to make sure that we pay nominal or whatever it is, minimal or whatever you want to call it, dividends, then they better tell you that right in the confidential memorandum. Because if they don't tell you that they're missing one of the key things in investment. I mean investment is you want to get dividends and you want to make a gain, a profit on disposition at the end. I mean if they’re not going to say that, I mean, that's false disclosure in my opinion.

[Emphasis added.]

Examination of Ludmer, transcript of July 4, 1990, pages 102-04.

See also page 107, pages 138-39, pages 169-71, 177-80 and pages 187-89.

[Translation.]

Q. Were you made aware of any representations in connection with the five purchase or five purchase of shares, were you made aware of any representations to the effect that either or both corporations had a fixed preset dividend policy?

A. I have answered that, the answer is no". There were no such representations and furthermore I have stated at least twice that if there had been such a policy, it should have been declared as a material fact in the explanatory memorandum.

Q. And have you been aware, sir, of any limits to the dividend paying possibilities on these common shares by either ustinian or Augustus prior to or subsequent to buying any of these Augustus and Justinian shares?

A. There were no limits, they do say in the dividend policy that they will use, I forget the exact wording, but it's a good chunk of the earnings for reinvestment purposes. But that doesn't mean like there's a number, that's a limit I mean, it just depends on what they're making you know. The more they make, the more they can pay out. So there is no absolute limit.

Examination of Ludmer, transcript of July 5, 1990, pages 68-69

[Translation.]

253. The appellants had no knowledge of any representation subsequent to either of their acquisitions which would suggest a pre-set dividend payment policy.

Cross-examination of Ludmer, transcript of November 22, 1990, page 27.

254. The dividend policy statement contained in the prospectuses of Justinian and Augustus was consistent with that of any new company wishing to consolidate its initial financial position before distributing its profits to its shareholders:

Q. Alright, would you indicate to his Honour what forms of returns you were contemplating at the time?

A. Well the only two returns that one could get were well, most likely were dividends and then profit on disposition. So those were the two returns to which I was referring.

Q. Alright now, as far as the dividends are concerned, I understand from this policy of Justinian, that they would accumulate earnings for reinvestment, at least initially. Now would that not suggest to you that you would not be looking to this company for dividends sir?

A. No, as I was saying this morning, I find that this kind of dividend policy is very typical in new companies where they first wish to accumulate earnings and then at the discretion of the Board of directors, they then decide how much of a dividend to declare.

Q. Were you aware of any limits on the dividends that this corporation could declare?

A. No, as I stated also earlier I was not aware of any limits, and if there were limits they should have been spelled out in the dividend policy as a material fact.

Q. So you weren't aware that the policy regarding minimal dividends or maximum dividends to be declared?

A. Not at all.

Q. From either end of the spectrum?

A. No, not from either end.

[Emphasis added.]

Examination of Ludmer, transcript of July 4, 1990, pages 126-27

255. Companies in general and nascent companies in particular do not distribute all their profits to their shareholders and reinvest part of those profits in their businesses because such an economic policy promotes their future growth:

[Translation.]

Q. Are you aware, Sir, of any policy from any of these companies whereby they would declare their entire earnings in a form of dividends?

A. No, none of them.

Q. What policy would you have found in a more prevalent policy from either these Canadian companies or those we see appearing on the TSE listing, which you have identified yesterday?

A. Well with maybe one exception, you know, they all declare a dividend which, some of them don't declare any dividends to start with, and the rest of them declare a dividend that would be small relative to the reinvestment of their retained earns. They reinvest most of their earnings for growth, and they declare a small dividend, that's typical of most corporations.

Q. And to your knowledge, is this common practice?

A. Yes, absolutely.

HIS HONOUR: You said that most companies, well, declared dividends. Did most also declare small dividends?

R. Yes. Otherwise, Your Honour, we would not have seen an average of 3.5 per cent in dividends. Obviously, companies make more than 3.5 per cent; otherwise, in borrowing money from the banks, they will never be able to repay. So they make much more, but companies that want to expand keep that in order to reinvest; otherwise, it makes no sense.

Examination of Ludmer, transcript of November 22, 1990, pages 125-26 and 129.

See also examination of Ludmer, transcript of July 5, 1990, pages 6-7, pages 12-16.

Examination of Ludmer, transcript of November 22, 1990, pages 111-12.

Cross-examination of Gutenplan, transcript of May 7, 1991, pages 128-129, 133, 139

256. The appellants claim that the dividend policy as described in the prospectus cannot reasonably be interpreted as suggesting a firm decision to pay token dividends to the shareholders of Justinian and Augustus.

257. Furthermore, the 1981 version of the prospectuses of Justinian and Augustus contains the following text describing a widespread policy of paying dividends based on profits realized and is not consistent with the interpretation which the respondent makes of it:

[Translation.]

DIVIDEND POLICY

The Fund accumulates the major portion of its earnings for reinvestment. However, in the past, it has been the policy of the Board of Directors of the Fund to declare and pay a dividend to shareholders for years in which the Fund has earnings, and it is anticipated that the Board of Directors will continue to follow this policy. Payment of dividends will be made in Canadian Dollars or any other currency selected by the Board of Directors of the Fund.

[Emphasis added.]

Exhibit A-5, volume II page 92; see also Augustus Exhibit A-7, volume II, page 193.

258. Ludmer's evidence concerning the payment of dividends by Justinian and Augustus is uncontroverted and undisputed.

259. Following his thorough investigation, supported by the service of demands on Ludco, Arnold, Ludmer, the banks, the attorneys and accountants, Gutenplan admitted that there was no evidence of any kind of dividend payment policy whatever pre-set by Justinian and Augustus, except that related in the prospectus and apart from the fact that Justinian and Augustus had paid a divided of US$1 for one or two years prior to its report:

[Translation.]

Q. So, if I understand your testimony correctly, there is nothing in the papers you have reviewed, in any of these three books, which would suggest a preset dividend paying policy by either Augustus or Justinian at the time you made up your report in 1981?

A. Nothing.

Q. Up to and including, I'm sorry, the time you made up your report?

A. Nothing which specifically stated that dividends would be limited to a certain dollar amount.

Q. On a yearly basis?

A. On a yearly basis.

Q. Very well. And the only thing you saw was dividends of a dollar being paid in fiscal 1979 and I take it, since your report is June ’81, fiscal 1980. Am I correct?

A. That plus the conclusions I arrived at from the reading of the various documents.

Q. I want to know the facts, Sir. Facts are, so far I have my understanding or two, you saw financial statements paying a dollar a share for fiscal 1979 and I would take it, fiscal 1980 or those financial statements which were available to you at the time, and we saw, those are the two documents I have seen wherein we have the dollars a share when you made up your report in June of '81?

A. That is correct.

Q. And there is nothing in all these papers which suggests a fixed rate of dividend being paid on a year to year basis by either these two corporations. Am I correct?

A. There was, one of the documents from the bank stated a nominal dividend would be paid as required for Canadian, for tax purposes.

Q. Yes, but nothing suggesting that there would be fixed amount being paid on an annual basis by either these corporations. Am I correct, Sir?

A. Yes, you are correct.

Q. Thank you.

HIS HONOUR: When you say "fixed amount", do you mean one dollar per share?

Me GUY DU PONT : Any fixed amount, Your Honour.

HIS HONOUR: Any fixed amount?

Me GUY DU PONT : Any fixed amount. Be it a dollar.

Q. Did you see any document suggesting that it be a dollar share, Mr. Gut- enplan?

A. The only thing I saw was nominal.

Q. And those are the words found in exhibit 23, tab 23, as I recall it, of volume II, exhibit R-50, but we're getting to that in a moment, where you saw this morning, I believe, my learned friend evidencing or referring to what a statement made by the bank manager of the Mercantile Bank, in 1978, saying there was a nominal dividend to be paid for tax purposes. Those are the words Mr. Gutenplan, I think, is referring to, am I correct, Sir?

A. Yes.

Q. Outside those words in that memo of 1978, by the bank manager was not testified?

A. I don't know if it was the bank manager or in the office, it was somebody within the bank.

Q. I assumed the bank manager, Your Honour, the witness is quite correct in correcting me. And, Mr. Gutenplan, can I take it, Sir, that there was nothing in the papers you have reviewed or audited or investigated, at the time, that would suggest to an investor such as Mr. Ludmer that these corporations would be paying a dollar a share for years on end?

A. There was nothing which specifically stated they would pay only a dollar a share.

Q. Were there any representations made, to your knowledge, Sir, to any of the investors — not to any of the investors — to Mr. Ludmer and his family, to your knowledge, of which you have become or would have become apprised of, sir, in the course of your investigation, that would suggest that the funds would only, the corporations would only be paying a fixed dividend of a dollar share for every year?

A. Not to my knowledge.

[Emphasis added.]

Cross-examination of Gutenplan, transcript of May 7, 1990, pages 104-09.

[Translation.]

260. The only knowledge attributed to the appellants of a pre-set dividend policy arose from the prospectuses and from the fact that a dividend of one dollar (U.S.) had been paid for the years previous to the Gutenplan report.

Q. Before December of 1980, Mr. Gutenplan, would you tell this Court, Sir, on what fact or facts did you rely on to form the opinion that my clients went into this arrangement "aware of the fact that the funds would only pay nominal dividends"?

A. As I mentioned, the only information I had was a — written information I had was an explanatory memorandum of one of the funds.

Q. And that showed that the dividends would be nominal, Sir?

A. Yes, it did.

Q. Alright, would you point out to where that exhibit is, sir?

A. It did not use the word nominal, but the way I interpreted that document, I came to that conclusion.

Q. And would you point out, would you draw the Court's attention to the document, sir, so we know what you're talking about?

A. It was based on what I saw, at that time, as being dividends received as opposed to interest claimed and also the dividend policy as stated in a document or one of the funds. On that particular document it was pages five and six.

Q. Alright?

A. This and the notes in my July 11, 1980 memorandum.

Q. And this document, would this be one of the memoranda you have previously identified as being the. . .

A. It may have been the memorandum of Darius as opposed to Justinian or Augustus.

Q. And is it fair to say, Sir, that Darius was not paying any dividends, at the time?

A. Darius’ dividend payments were similar to those of Justinian and Augustus.

Q. Keep your finger at page or at exhibit 24 and if Your Honour would turn to exhibit 22?

HIS HONOUR: Exhibit or tab?

Me GUY DU PONT : Tab 22, I'm very sorry, Your Honour.

HIS HONOUR: And it's R or?

Me GUY DU PONT: R-49, still, Your Honour, 22, Your Honour.

Q. Is the paragraph 6, which you have described a summary if not a quotation of one of the offering memoranda, is this statement the basis for your conclusion that these corporations would pay only nominal dividends?

A. That plus what I had seen in certain information given to me by referring auditors.

Q. What information was that, sir?

A. I had received referrals from auditors other than Mr. Hirsch, where they told me that certain investors had made certain investments in these funds, they claimed certain interest expense and they received certain amounts of dividend.

Q. And how much were the dividends?

A. The dividends were a dollar a share.

Q. Alright. And that was in 1980? Or before 1980?

A. It would have This was information given to me by the auditors at the time.

Q. When you say "the auditors at the time”, you mean people other than Mr. Torino or Mr. Hirsch?

A. No, it would most probably would have been Mr. Torino.

Q. So Mr. Torino told you that some investors were received a dollar a share?

A. l have to. I don't remember exactly what he told me, yet he did give me certain information as to the investment and as to interest claims.

Cross-examination of Gutenplan, transcript of May 7, 1991, pages 166-71

[Translation.]

Me GUY DU PONT : As a result of your investigation, Mr. Gutenplan, could you tell this Court if you found any documents in my clients’ files which would indicate that they knew in advance that these corporations would be paying only nominal dividends in the future?

A. Based on what I recollect, without going through all the documents again, to see where each document came from, I can’t say. However, I don't remember which copy of the explanatory memorandum your client had. I believe you implied, earlier today, that the copy of the explanatory memorandum he had made reference to the dividend policy taken into account tax consequences. That's to be corrected if I'm wrong in that.

Q. With the exception of this statement about tax consequences, my question is: Did you find, as a result of your investigation in 1981, any documents or evidence that would suggest that my clients knew, in advance, of a policy to pay a dollar a share or a policy by these corporations to pay a dollar a share in the future?

A. Not to my recollection.

Q. Are you aware, sir, of any fact or facts that show or tend to show that my clients knew, as a result. . . sorry, I’ll rephrase the question, Your Honour. As a result of your investigation, sir, are you aware of any fact or facts which show or tend to show that my clients knew, in advance, that these corporations would only be paying a dollar a share in all subsequent taxation years?

A. Not to my recollection.

Q. Thank you. Mr. Gutenplan, is the language, to your recollection, in 1981, sir, is the language with respect to the dividend policy in Spartacus along the same lines as that we have seen for Justinian and Augustus?

A. I do not recollect.

Cross-examination of Gutenplan, transcript of May 7, 1991, page 173-81.

[Translation.]

. . . was there anything suggesting, in any of the material you have reviewed so far, a fixed dividend policy as far as paying a fixed amount?

A. As far as paying a fixed amount. . . .

Q. Or on annual basis?

A. Or on annual basis, nothing other than what I saw them doing. But, as far as documents laying it out, no.

Q. So, if I understand your testimony correctly, there is nothing in the papers you have reviewed, in any of these three books, which would suggest a preset dividend paying policy by either Augustus or Justinian at the time you made up your report in 1981?

A. Nothing.

Q. Up to and including, I'm sorry, the time you made up your report?

A. Nothing which specifically stated that dividends would be limited to a certain dollar amount.

Q. On a yearly basis?

A. On a yearly basis.

Q. Very well. And the only thing you saw was dividends of a dollar being paid in fiscal 1979 and I take it, since your report is June 1981, fiscal 1980. Am I correct?

A. That plus the conclusions I arrived at from the reading of the various documents.

Q. I want to know the facts, sir. Facts are, so far I have my understanding or two, you saw financial statements paying a dollar a share for fiscal 1979 and I would take it, fiscal 1980 or those financial statements which were available to you at the time, and we saw, those are the two documents I have seen wherein we have the dollars a share when you made up your report in June 1981?

A. That is correct.

Q. And there is nothing in all these papers which suggests a fixed rate of dividend being paid on a year to year basis by either these two corporations. Am I correct?

A. There was, one of the documents from the bank stated a nominal dividend would be paid as required for Canadian, for tax purposes.

Q. Yes, but nothing suggesting that there would be fixed amount being paid on an annual basis by either these corporations. Am I correct, sir?

A. Yes, you are correct.

Cross-examination of Gutenplan, transcript of May 7, 1991, page 105-07.

[Translation.]

And, Mr. Gutenplan, can I take it, sir, that there was nothing in the papers you have reviewed or audited or investigated, at the time, that would suggest to an investor such as Mr. Ludmer that these corporations would be paying a dollar a share for years on end?

A. There was nothing which specifically stated they would pay only a dollar a share.

Q. Were there any representations made, to your knowledge, Sir, to any of the investors — not to any of the investors — to Mr. Ludmer and his family, to your knowledge, of which you have become or would have become apprised of, Sir, in the course of your investigation, that would suggest that the funds would only, the corporations would only be paying a fixed dividend of a dollar share for every year?

A. Not to my knowledge.

Cross-examination of Gutenplan, transcript of May 7, 1991, page 108-09.

[Translation.]

261. Referring to the prospectus, Mr. Gutenplan testified:

Q. Mr. Gutenplan, do you see any restriction whatsoever in any of these documents or this document, with respect to dividends being paid by these corporations?

A. Other than the comment under" Dividend Policy”, I see no restrictions.

Cross-examination of Gutenplan, transcript of May 7, 1991, pages 111-12.

See also pages 97-101.

[Translation.]

Q. Is it not fair to say, sir, that having regard to the conclusions you have in paragraph 1, that the stated policy of the fund was to initially accumulate the greatest portion of its earnings for reinvestment? And not simply as a rule to accumulate the greatest portion of earnings for reinvestment?

A. Initially, it is what they stated on the document.

Q. Thank you. Number two, sir, when you're referring to Spartacus material, you’re referring to these examples in a memorandum that you do not have with you, am I correct?

A. That is correct.

Q. You're not referring to the official offering memorandum which was circulated to the investors or potential investors for Spartacus shares?

A. That is correct.

Q. Thank you.

Q. And number three, “the established dividend policy of the funds to pay a dollar a share" is based, as I understand your testimony so far, on the, what you saw in the financial statements?

A. Correct.

Q. Being a dividend being paid in fiscal 1979 and 1980, as I recall it?

A. That is correct.

Q. Any other fact or facts, sir, tending to establish an established dividend policy?

A. Those are the only facts I had.

Q. Thank you

Q. And in making these conclusions, Sir, in nineteen eighty-one (1981) and giving your evidence this morning, is it a fair statement to say that you have taken into consideration all the exhibits found in the three volumes, or exhibit R-49, R-50 and R-51?

A. Not everything there. At least one financial statement in here that I noticed that is dated subsequent.

Q. Subsequent, alright. But at least, it includes most of what's in there?

A. Most

Q. There's nothing else, it’s all in there, there may be more, but there's nothing more?

A. Nothing more regarding Augustus or Justinian.

Cross-examination of Gutenplan, transcript of May 7, 1991, page 184.

262. As to the information obtained from the bank to which Gutenplan referred, apart from the fact that his testimony on this factor constitutes inadmissible hearsay and that the Bank (and the author of the document) was not heard, Gutenplan admits that he had no idea where the Bank's information came from.

Cross-examination of Gutenplan, transcript of May 7, 1991, pages 192-93.

263. The payment of dividends of one dollar (U.S.) per share, apart from the fact that it occurred after the fact, that is after the purchase of the shares and that it was the result of decisions made by persons over whom the appellants had no control or influence, was not unusual or surprising, having regard to the yield paid by public companies, or symptomatic of a pre-set policy:

[Translation.]

Q. Mr. Ludmer, this first dividend payment was in 1979 and was for a dollar per share, as I understand it. Now if I turn to page 1077, is it not fair to say that you also received another dollar a share dividend in 1980?

A. Yes.

Q. Page 1080, Exhibit A-31(c) for 1981, again a dollar a share for Justinian.

A. Yes.

Q. Nineteen eighty-two, page 1084 a dollar a share, Mr. Ludmer?

A. Yes, that's correct.

Q. Did that not indicate to you any form of pattern, sir, by that time?

A. Well so far we've seen for the first three years dividends, we see a pattern of a dollar a share. What that indicated to me was nothing more or less than that's what the board of directors have declared for those specific years.

Q. And what about the future at that time, sir?

A. The future is not affected by what the board has done in the past.

Q. And that was your understanding, that was your perception at the time, sir?

A. Absolutely. I mean, at Steinberg’s, we unfortunately cut the dividend. It’s more favourable when companies increase the dividend, however, one never knows.

Examination of Ludmer, transcript of July 5, 1990, page 88.

[Translation.]

. . .And again I'll put the same question to Mr. Ludmer: in connection with Augustus, Mr. Ludmer, would this recurring a dollar a year share payment, sorry dividend payment on shares, does not suggest to you a pattern, sir?

A. Oh, one has to understand that in declaration of dividends by companies, that it is not unusual at all for a company to maintain a certain dividend level for a number of years before changing its dividend. One doesn't find in the usual course that corporations change their dividend on an annual basis. In fact I would say that's rare.

Examination of Ludmer, transcript of July 5,1990, pages 89-90.

264. Furthermore, a dividend of US$1 per share constituted a respectable dividend:

[Translation.]

Q. Me GUY DU PONT : Mr. Ludmer, is it fair to say that over the ten years, over the period 1978 and 1985, Ludco received approximately $350,000 worth of dividends from Justinian and Augustus?

A. Well we have here, on exhibit A-60, Ludco having dividends of some two hundred and fifty five thousand ($250,000).

Q. Oh, I’m sorry. Ludco and 2154, I’m sorry?

A. Yes, Ludco and 2154 was somewhere over $400,000.

Q. Alright, not including the others?

A. Oh, just from Justinian and Augustus.

Q. Justinian and Augustus?

A. Yes. Then we would be just a little somewhere over $300,000.

Q. Alright. Did you consider those dividends at the time as being nominal dividends, Sir?

A. To me, none of them were nominal from day one there was no nominal dividends.

Q. Could you tell the Court why you don’t consider those dividends as being nominal, Sir?

A. First of all, I explained that if one looks at Canadian Corporations in general, one sees the dividends don't match the interest expenses, we talked about that just five minutes ago, they don't match. And in the actual declaration of dividends, companies declare anything from vary, vary [sic] minor dividends indeed, a little up to five, six per cent dividends. So some of the utilities may go a little bit higher, but it doesn't match interest, never.

So the question is, what is nominal? I don’t consider these nominal and I consider these substantial sums of money earned in good faith on a stock investment which would be no different if I invested in Steinberg, which by the way I did, with borrowed money. Nobody ever said to me that that was not kosher. Nobody challenged the interest deduction, like hundreds of thousands of other Canadian taxpayers.

Steinberg paid $0.50 a share dividend on a $40 stock, which if you work it out, comes to a little over one per cent and nobody ever questioned it and nobody would question many stocks in Canada that paid much less than that. So I don’t see where this whole idea of nominal dividends entered into the picture at all!

Q. Would you turn to A-61, sir, page 1307. If I would put the same questions to you, Mr. Ludmer, in connection to dividends received by each of children, would your answers be the same?

A. Exactly the same answer.

Re-examination of Ludmer, transcript of November 22, 1990, pages 122-24.

Re-examination of Ludmer, transcript of November 22, 1990, pages 115-16.

265. In any case, not only is this concept of a “nominal dividend" foreign to paragraph 20(1)(c) I.T.A., but the attempts to apply this concept also caused complete confusion and resulted in an arbitrary application of the I.T.A., to say the least, and in a discriminatory application of the respondent's policy of which the appellants were victims, as witness the testimony of his officers.

(b) Tirabasso

266. The auditor Tirabasso admitted he applied this concept purely arbitrarily ("feelings"), having no standard or policy as to what constituted a “token” dividend and in reality having as his only point of reference the fact that the companies for which the appellants had borrowed in order to finance the purchase of shares were so-called "offshore" companies. Tirabasso had to apply this concept notwithstanding the fact that the deductibility of the interest expenses claimed was consistent with the respondent's own policy and further notwithstanding the fact that those investments were identical, to all intents and purposes, to shares of Bell Canada:

[Translation.]

Me GUY DU PONT: Q. Mr. Tirabasso, what are nominal dividends?

A. The way I understand it, it’s a small amount.

Q. What percentage, sir?

A. I would say, relatively speaking — depending on the interest rates — one per cent lower.

Q. All right. So do I understand properly, sir, that Revenue Canada's position is that any dividend which is below one per cent, equal or below one per cent, is considered to be nominal?

A. No, it's not Revenue Canada's position.

Q. All right. Would you tell me, sir, what is Revenue Canada's position at the time of your assessments as to what percentage constituted a nominal dividend?

A. Revenue Canada has no position on what's nominal, I wouldn’t . . . I don't know really what it is.

Q. So in making your reassessments, sir, would you tell the Court how an assessor in your position would be able to, what guidelines did an assessor in your position have to establish what was a nominal rate of return by way of dividend on a share?

A. I have no guidelines and I would just go by my own feelings.

Q. Are you:telling this Court, sir, that it would be left up to every assessor to go on his own feelings as to what constituted a nominal rate of return by way of dividend?

A. There is no written policy on nominal.

Q. Is there an oral one, sir?

A. No.

Q. So on what basis are assessors to determine what are nominal rates of return on shares?

À, It's left up to them, I would say, yes.

[Emphasis added.]

Cross-examination of Tirabasso, transcript of May 8, 1991, pages 118-20

267. As to the factors determining the token nature of a dividend, Tirabasso stated:

[Translation.]

Me GUY DU PONT : Q. All right. Tell us, sir, what factors did you consider in 1984 or 1985, at the time of your audit and assessment, to determine that these dividends were in fact nominal dividends?

A. The amount of interest that was paid versus the amount of dividends received.

Q. And did you compare that with other rates of interest being paid and other rates of dividends being received?

A. I would not compare that to dividends and rates, I would compare it to bonds.

Q. My question, sir, is: did you compare these rates of interest being paid to

the rates of dividends being received at the time from other corporations?

A. No, my reassessment was not based on that.

HIS HONOUR: Do you mean, for instance, by the company or by the other taxpayers involved in this case; they received dividends or they received . . . that's what you mean?

Me GUY DU PONT: I'm not saying. . . .

HIS HONOUR: Compared the amount that they paid and the amount that they received?

Me GUY DU PONT: Compared the amounts that they've paid and the amounts that they've received against what was being paid to banks and what was being received from other corporations.

Q. So what was the basis for your reassessment then, sir?

A. The basis of the reassessment is the Tax Avoidance Communique 84-R-1. . . .

Q. Yes.

A. . . .and within that communique, I believe it does mention nominal dividends and I interpreted the amount of dividends that were received by Ludco Enterprises as nominal. But it was my interpretation.

Q. And the reason for that was what, sir?

A. The amount of dividends received versus the interest expense claimed.

Q. I see, all right. And what were the rates at the time?

A. I did not investigate the rates at the time. Do you mean the bond rates?

Q. No, I mean the interest rates and the dividend yields.

A. Well, if you analyze the dividend yields, the dividends received by Ludco versus its interest received, the amount is . . . I think it’s less than one per cent, I believe.

It's approximately one per cent. . . yes, that's one per cent.

So that if you look at the overall market at the time, and I think it must have been maybe 10 per cent or 12 per cent, I really don't know. . . .

Q. What was 10 or 12 per cent —12 per cent, sir?

A. The bank rate.

Q. On moneys borrowed?

A. Earnings. Earnings, dividends versus earnings or interest earnings.

Q. I'm sorry. What are you talking about? Are you talking about the interest we would get on deposit. . . .

A. That's right.

Q. . . . or the interest that we would pay to the bank on a loan?

A. To pay the bank would be much higher than the interest paid on loans.

Q. I see. So you're contrasting this rate. . . .

A. The dividend rate is income and I contrasted to income earned on term deposits, for example.

Q. I see. Were there any other comparisons made, sir?

A. No.

Q. All right. And do I understand your testimony to be the fact that at the time, sir, rates or the bank rate was approximately eight per cent or something around that area, sir?

A. You are talking at the time, meaning 1977?

Q. At the time you reassessed.

A. At the time I reassessed, 1985, I didn't investigate what the rate was — I don't remember the rates — maybe five per cent, I'd have to look it up.

Cross-examination of Tirabasso, transcript of May 8, 1991, pages 122-27

[Translation.]

A. And it’s not specified anywhere in our policy. I interpreted "nominal" to be small amounts and I said I compared the total dividend received versus the amount of interest expense claimed.

Q. I’m sorry. So it wasn't against interest on term deposits. . . .

A. No, non.

Q. . . .it was against interest expense?

A. Well, I looked at the case itself, at the actual particular facts in Ludco Enterprises.

Q. I see. So my question to you, sir, then is: it wasn't against yields on term deposits?

A. No, that was not the case.

Q. I'm sorry. Then you're quite right, Your Honour, I was mistaken because I understood he was comparing it with something else.

Cross-examination of Tirabasso, transcript of May 8, 1991, page 128.

[Translation.]

Q. All right. Would you indicate to the Court, sir, what rate or what criteria or standard did you apply to determine if, in those situations where you were dealing with nominal . . . or let me backtrack.

Did you apply any comparison, did you make any comparison between the rate of return of a dividend and the money they were paying at the bank?

A. No.

Q. Why not?

A. In most circumstances that I remember auditing, shareholders would borrow

money to invest in their own personal company which paid no dividends.

Q. And in those contexts, sir, would Revenue Canada allow the expense?

A. Yes, it would.

Q. Even though there was no dividend being paid?

A. We have a policy on that.

Q. And what was that policy, sir?

A. It's an interpretation bulletin, and don't ask me to go and. . . .

Q. In general terms, sir, what was the policy at the time?

A. If it's incurred to earn income, we will allow it.

Q. All right. And in this context you have just described, of an individual borrowing money from the bank to invest in his own corporation, would Revenue Canada allow the interest expense?

A. In most circumstances, they would.

Q. Even though there were no dividends being paid?

A. Yes.

Q. That was the policy at the time of your reassessment, sir?

A. Yes.

Q. All right. And did you also encounter cases where investors had borrowed money to buy into publicly-traded corporations, sir, or buy shares of publicly- traded corporations?

A. Yes, there are.

Q. And did you also apply the same rule as to whether or not a determination would be made about the existence of a nominal dividend or not?

A. The rule was not the existence of a nominal dividend, it was the fact that the investment produces income.

Q. I see. And it was enough for the share to yield a dividend?

A. Basically speaking, that would be.

Q. All right. And is there a percentage over which the expense was allowable and under which the expense was not allowable?

A. No, there is no policy.

Q. So do I take it then, sir, it is left to the assessor's own determination whether it would be proper and appropriate in the circumstances?

A. With regards to?

Q. Deductibility of interest to buy into shares.

A. Buy into shares . . . the law is specific: it has to earn income following the law, it's not up to the. . . .

Q. I’m talking about policy, sir.

A. The policy, I think it's written in the IT bulletin.

Q. Okay. Would you go to exhibit A-203, sir. You're familiar with the policy, are you, Mr. Tirabasso?

A. Yes.

Q. You're familiar [with] their outlines?

A. Yes, I am.

Q. And you’re familiar with question and answer number one, sir?

A. The question number one:

Can a taxpayer claim as a deduction interest paid to purchase shares that are precluded from paying taxable dividends?,

and the answer is yes.

Q. Is your understanding of “ precluded”, sir, meaning that the shares would not pay any dividends?

A. That's right, that’s what it means.

Q. Isn't my understanding then, sir, that according to this document Revenue's policy was to allow interest expense, even for shares for which there would be no dividend being paid:or possibly paid, or potentially paid?

A. As of this date, it's dated February 29,1976. . . .

Q. All right.

A. . . .this seems to be the answer.

Q. If you’d look to exhibit A-204, sir. . . . I’m sorry, not 204. R-47, please.

HIS HONOUR: R-47?

Me GUY DU PONT: I'm sorry, Your Honour, yes.

Q. This document, sir, is '84?

A. Nineteen eighty-four.

"Can a taxpayer deduct interest in respect of funds used to purchase speculative stock?"

and the. . . .

Q. You notice that question number one has now disappeared as of '84.

A. Yes.

Q. So this policy was in force from 1976 up to and including 1984, or the date indicated in this document.

A. Yes.

Q. Do I take it then, sir, that Revenue Canada's policy at the time was to allow interest in shares which were precluded from paying any dividend to allow the interest expense on money borrowed to buy those shares? According to those documents, Sir.

A. Well, according to this document, I must say yes.

Q. Thank you.

[Emphasis added.]

Cross-examination of Tirabasso, transcript of May 8, 1991, pages 129-34.

268. The successive positions advanced and withdrawn by the auditor responsible for the issue of reassessments against the appellants clearly shows the arbitrary nature of the standard used by the respondent to attack this form of investment, which, in his view, was unacceptable. However, what was unacceptable, according to the respondent, in these investments was not the deduction of interest which was used to finance them, but solely the income which these companies generated abroad. Such a misuse of the I.T.A. for the reasons expressed below should not be tolerated in the appellants' view.

(c) Gutenplan

269. Gutenplan considered these token dividends because the amount, in his view, was very small. However, he was unaware of the yield of the other shares traded on the stock exchange, of how that of Justinian and Augustus compared thereto and of the rate of interest charged by financial institutions on loans.

[Translation.]

Q. Did you know, in 1981 what was the rate of return, the average rate of return on publicly-traded stock on either the Montreal, Toronto or Vancouver Stock Exchange, Sir?

A. No, I did not.

Q. Do you know today, Sir?

A. No, I do not.

Q. Thank you. So would you tell the Court how one can establish if these dividends were nominal, or how did you establish that these dividends were nominal, Sir? I'm sorry, let me rephrase that, Your Honour because my question is not appropriate.

Why would you consider these dividends being nominal, Mr. Gutenplan, in 1981, at the time, when you knew at that time, of course?

A. At that time, it was a minimum amount of a dollar a share on shares having. . .on which investors had to pay substantial amounts in order to invest and the word nominal was also used by other parties.

Q. Alright?

A. Which confirmed my thinking.

Q. And the only other party is the bank?

A. That is the only one I could recall right now.

Q. Alright. Are there others?

A. That is all I can recall right now.

Q. Fine. Did you have any inquiries to be made, at the time, to find out what was being paid on shares being transacted on either of these stock exchanges or any stock exchange, in 1981, sir?

A. No, I did not.

Q. Would you indicate to the Court the guidelines issued by your Department,

in 1981, which would define the concept of nominal return on shares.

A. We didn't use just the concept of nominal return on shares. What we used was interest on moneys borrowed to earn income from property, was deductible. In this particular case, and also — there's a section in the Act, you mentioned earlier, it was subsection 9(3), said: “ Capital gain from the sale of the shares was not considered income from the property" — and in this case, based on what I saw, I came to a conclusion that there was no way of the income from the property, as opposed to capital gain, being equal to the . . . being earned other than a loss, if interest would be claimed.

Q. Mr. Gutenplan, did you know — and I advise you to be careful, because — I'll rephrase my question to avoid any problems. Did you know, in 1981, what the rate of interest was on moneys borrowed? What was the prime rate on moneys borrowed from a bank, in 1981?

A. I probably didn’t. I can't say for certain.

Q. Do you recall it today, sir?

A. I do not recall it today, no.

Cross-examination of Gutenplan, transcript of May 7, 1991, pages 116-19.

[Translation.]

Q. Me GUY DU PONT: Mr. Gutenplan, in 1981, sir, were you aware or let me put it this way: Before June of '81, were you aware of any corporation paying any kind of return by way of dividend equal to the amount of interest for the prime rate of interest being charged on loans or on borrowed money at the time?

A. Not to my personal recollection.

Q. Is it not fair to say, sir, that none of these corporations, sir, were paying any amount equal to the rate or prime rate being asked by the banks on moneys borrowed from them?

A. By these corporations? You mean which, our four or?

Q. No, the Canadian, and publicly-traded company, sir?

A. I, personally, do not know of any.

Q. Would you indicate to His Honour, what points of reference you had in mind, at the time, sir, to formulate the conclusion that these were low dividends?

A. Based on the investment required per share, this one dollar was a very low percentage,

Q. Alright. With what did you compare it, at the time, sir, to arrive at the conclusion it was a low dividend?

A. I do not remember exactly with what.

Q. Did you compare it with anything else, sir, or any other dividends being paid by any other corporation, sir?

A. I do not remember.

[Emphasis added.]

Cross-examination of Gutenplan, transcript of May 7, 1991, pages 141-42.

270. The concept of token dividends used by Gutenplan as the basis of an attack on the appellants’ interest deduction was expressly dismissed by the respondent in 1981 and 1982 because it was untenable and contrary to the I.T.A. and to his own policy on the matter. However, paragraph 20(1)(c) underwent no legislative ad- mendments of any consequence between 1981 and the date of the reassessments for the relevant period.

(d) Calderwood

271. On June 21, 1984, the communiqué TA-84-R-1 was published. [8] This communiqué expressly concerned so-called "offshore" companies and described in general terms the characteristics of those companies whose:

. . . investment policy . . . is to pay dividends or not to pay any dividends and to reinvest profits in order to increase the value of their shares.

Exhibit R-52, pages 2 and 3, paragraph 5

272. The respondent's position on the deductibility of interest was as follows:

The deductibility of the interest on the borrowed sums. . . . must be disallowed in accordance with subsection 9(3) and paragraph 20(1)(c). Investors’ intention is usually to realize capital gains rather than income from property.

Exhibit R-52, page 5, paragraph A.

273. Calderwood's definition of "nominal" or "token dividend” was just as arbitrary as that of Gutenplan and Tirabasso:

[Translation.]

Q. Would you indicate to the Court, please, sir, what guidelines or what criteria were given to the auditors or assessors to determine what was considered nominal dividends, sir?

A. There was no guidance given to the field people on that subject.

Q. Would you indicate to the Court, sir, what or how the field people were to define the concept of the nominal dividends?

A. Well, we would expect them to use a normal meaning for such and such a term, but they still could not act on their own in any event and still had to go to head office, tax avoidance.

Q. Alright. What was the percentage for a dividend to become nominal or to leave the nominal category, sir? What way of return were you looking at as being nominal, at the time?

A. We didn't have any criteria set, we would just take a small amount and made it nominal.

Q. Alright. Were there any comparisons made at the time, sir, to your knowledge at the time? Were there any comparisons made against the going rates of return on dividends, on publicly-traded corporations in this country or elsewhere?

A. No, there was not.

Q. Were any comparisons made to the going rate or prime rate of interest being paid on moneys borrowed to invest inter alia in shares on publicly-traded corporations?

A. No, there was not.

Q. Was there any correlation made or to be made with respect to the rate of interest to be paid to the bank and the rate of return on a share, by way of dividend, to determine whether the return was nominal or not?

A. No, there was not.

Q. Is it also not fair to say, Mr. Calderwood, that, at the time, and in 1984, the rates, prime rate was much in excess of any rate or any return on dividends of publicly held corporations on any of the Canadian Stock Exchanges?

A. It likely was, yes.

Q. Is it fair to say, sir, that it was much greater, the rate of interest one was paying to borrow money to buy into shares which were publicly-traded, was much greater than the return one would expect on the dividend on those shares, as a rule, at that time?

A. I couldn't really say.

Q. You don’t know?

A. No.

[Emphasis added.]

Cross-examination of Calderwood, transcript of May 7, 1991, pages 248-50. Cross-examination of Calderwood, transcript of May 7, 1991, pages 268-70. Exhibit A-192, volume XIII, page 2422, at page 2426.

Exhibit A-193, volume XIII, page 2432, at page 2433.

Examination of Ludmer, transcript of July 5, 1990, page 178.

274. No matter the auditor or officer who testified, the arbitrary nature of the concept of “nominal dividend” was amply demonstrated. The application of a statutory provision of the importance of paragraph 20(1)(c) I.T.A. to a field as important and essential to the economy as that of the financing of incorporated businesses, public or private, small or large, cannot be left in such a state of uncertainty. The appellants claim that the deductibility of their interest is contingent on paragraph 20(1)(c) I.T.A., which does not recognize such a concept. It is intolerable that the respondent applies paragraph 20(1)(c) I.T.A. by introducing a concept as arbitrary as this and thus assumes a function which was and is still incumbent upon Parliament.

275. The appellants claim that the rate of dividends paid by Justinian and Augustus, when compared to the average yield of Canadian public corporations, cannot in any case be characterized as token, and Ludmer testified under oath that he did not know in advance what dividends Justinian and Augustus would pay, but that he had bought on the basis of the potential of those shares, and that evidence was uncontroverted.

5.04 Respondent's argument concerning paragraph 20(1)(c) of the Act

5.04.1 Respondent's general argument

The respondent's general grounds are described at pages 1 to 14 of the respondent's submission, and they read as follows:

First proposition

If the interest expense was incurred for the purpose of producing a capital gain, it is not in law an expense made for the purpose of earning income. Thus, an expense made for the purpose of earning income is not the equivalent of an expense made for the purpose of realizing a capital gain.

Second proposition

The expression “for the purpose of earning income” means in law to make a profit, that is a net positive income after expenses, not gross income (for example, here, dividends).

Third proposition

It is clear that the appellants wanted to make money in the instant case. It is also clear that the MANNER in which they intended to make money was essentially through the increase in value of the shares, by their capital gain (“ capital accretion"). That was the purpose of this complex stratagem.

Summary of investment (in millions)
Amount invested:	$7.5
Value of shares at time of sale:	16.6
(Value therefore more than doubled)
Capital accretion — Capital gain:	9.1
Dividends:	0.6
Interest deducted:	$6.1

Documentary evidence of the respondent, Exhibits R-57, R-58 and R-62: see Schedule I to this submission for a breakdown of each of the amounts.

(A) Rules of interpretation of taxation statutes with regard to a provision of exception

The courts have for some years undeniably tended away from a strict interpretation of the taxation statutes. On this point, one may refer in particular to Stubart and Golden, supra.

The trend in recent Supreme Court judgments, including Bronfman Trust, supra, is to try to “ascertain the true commercial and practical nature of the taxpayer's transactions” (reasons of Dickson, C.J. in Bronfman Trust, at page 52 (C.T.C. 128; D.T.C. 5067)).

In Bronfman Trust, Dickson, C.J. wrote, in particular, as follows at pages 52-53 [(C.T.C. 128; D.T.C. 5067-68)].:

I acknowledge, however, that just as there has been a recent trend away from strict construction of taxation statutes (see Stubart, supra, at pages 573-79 (C.T.C. 313-16; D.T.C. 6321-24), and Golden, supra, at pages 214-15 (C.T.C. 277; D.T.C. 6140), so too has the recent trend in tax cases been towards attempting to ascertain the true commercial and practical nature of the taxpayer's transactions. There has been, in this country and elsewhere, a movement away from tests based on the form of transactions and towards tests based on what Lord Pearce has referred to as a "common sense appreciation of all the guiding features” of the events in question: B.P. Australia Ltd. v. Commissioner of Taxation of Australia, [1966] A.C. 224, [1965] 3 All E.R. 209 (P.C.), at page 264 (All E.R. 218). See also F.H. Jones Tobacco Sales Co., [1973] C.T.C. 784, 73 D.T.C. 5577, at page 790 (D.T.C. 5581), per Noël, A.C.J.; Hallstroms Pty. Ltd. v. Federal Commissioner of Taxation (1946), 8 A.T.D. 190 (High Ct.), at page 196, per Dickson, J.; and Cochrane Estate v. M.N.R., [1976] C.T.C. 2215, 76 D.T.C. 1154 (T.R.B.), per Mr. A.W. Prociuk, Q.C.

However, immediately after recalling these principles, Dickson, C.J. took care to say that this is clearly a laudable trend provided that it is consistent with the text and purposes of the taxation statute, and he added that that does not mean, however, that a deduction such as that provided in paragraph 20(1)(c) loses all its strictures with regard to the conditions required for entitlement to the deduction. He wrote as follows on this subject [at page 53 (C.T.C. 128-29, D.T.C. 5067)]:

This is, I believe, a laudable trend provided it is consistent with the text and purposes of the taxation statute. Assessment of taxpayers' transactions with an eye to commercial and economic realities, rather than juristic classification of form, may help to avoid the inequity of tax liability being dependent upon the taxpayer's sophistication at manipulating a sequence of events to achieve a patina of compliance with the apparent prerequisites for a tax deduction.

This does not mean, however, that a deduction such as the interest deduction in subparagraph 20(1)(c)(i), which by its very text is made available to the taxpayer in limited circumstances, is suddenly to lose all its strictures.

In other words, paragraph 20(1)(c) is a provision of exception to the rule providing that the financing charges are not, in principle, deductible because they are in the nature of capital. Consequently, all the conditions of paragraph 20(1)(c) must be strictly met in order to permit the deduction of an interest expense. On this point, the well-known work Ward's Tax Law and Planning, provides the following [at page 4-188.6]:

Because paragraph 20(1)(c) is an exception to the general prohibition on the deduction of capital expenses, all of its requirements must be strictly met in order to permit the deductibility of interest costs.

[Emphasis added.]

The courts have acknowledged the restrictive nature of paragraph 20(1)(c) as well as the strict nature of the conditions which must be met in order to benefit from it, to such a degree that they have gone so far as to disallow the deduction of interest charges even if general commercial principles would have permitted it. In Bowater Canadian Ltd. v. The Queen, [1987] 2 C.T.C. 47, 87 D.T.C. 5287, at pages 52-56 (D.T.C. 5291-94), leave to appeal denied by the Supreme Court of Canada), the Federal Court of Appeal dismissed the claim that interest charges were deductible in accordance with general commercial principles without regard to paragraph 20(1)(c). It therefore follows that the deduction of interest can be allowed only under paragraph 20(1)(c), not paragraph 18(1)(a) of the Act.

(B) Object of paragraph 20(1)(c)

I. Principle

An interest expense is not in principle deductible in computing a taxpayer's income if it was incurred in respect of a claim or a debt in the nature of capital. An interest expense is essentially a capital expense deduction which would in principle be prohibited by paragraph 18(1)(b) of the Income Tax Act (hereinafter" I.T.A.").

It will be remembered on this point that Rand J. of the Supreme Court wrote the following in Canada Safeway Ltd. v. M.N.R., [1957] S.C.R. 717, [1957] C.T.C. 335, 57 D.T.C. 1239 [at page 727 (C.T.C. 344; D.T.C. 1244)]:

It is important to remember that in the absence of an express statutory allowance, interest payable on capital indebtedness is not deductible as an income expense. [9]

In Sherritt Gordon Mines Ltd. v. M.N.R., [1968] C.T.C. 262, 68 D.T.C. 5180, Kerr, J. of the Exchequer Court wrote [at page 283 (D.T.C. 5193)):

I think there is no doubt that the interest is a capital outlay, the deduction of which in computing income for a taxation year, is prohibited by paragraph 12(1)(b) unless its deduction is expressly permitted by some other provision of the Act.

Lastly, in Bronfman Trust, supra, Dickson, C.J. wrote as follows [at page 45 (C.T.C. 124; D.T.C. 5064)]:

It is perhaps otiose to note at the outset that in the absence of a provision such as paragraph 20(1)(c) specifically authorizing the deduction from income of interest payments in certain circumstances, no such deductions could generally be taken by the taxpayer. Interest expenses on loans to augment fixed assets or working capital would fall within the prohibition against the deduction of a "payment on account of capital" under paragraph 18(1)(b);

The statutory exception provided at paragraph 20(1)(c) is therefore part of the context in which the deduction is in principle prohibited because it is in the nature of capital under paragraph 18(1)(b). Paragraph 20(1)(c) thus sets aside the prohibition of paragraph 18(1)(b) for the purpose of deducting interest if and only if the conditions set out in paragraph 20(1)(c) are met. We shall now see that, in the instant case, one of the essential conditions provided in paragraph 20(1)(c) is not met, that is that the money borrowed be used for the purpose of earning income.

II. Parliament's intention

What then was Parliament's intention in allowing the interest deduction despite the prohibition provided in paragraph 18(1)(b)? The Supreme Court recently answered this question by saying that it was in order to encourage the accumulation of capital that would produce TAXABLE income. In Bronfman Trust, supra, Dickson, J. wrote as follows [at page 45 (C.T.C. 124; D.T.C. 5064)]:

I agree with Marceau, J. as to the purpose of the interest deduction provision. Parliament created subparagraph 20(1)(c)(i), and made it operate notwithstanding paragraph 18(1)(b), in order to encourage the accumulation of capital which would produce taxable income.

[Emphasis added.]

Dickson, J. also added the following on the subject [at pages 53-54 (C.T.C. 129; D.T.C. 5067)]:

In my view, the text of the Act requires tracing the use of borrowed funds to a specific eligible use, its obviously restricted purpose being the encouragement of taxpayers to augment their income-producing potential.

Not all interest is therefore deductible: there are eligible uses and ineligible uses of borrowed money.

If the use is ineligible, the result is that the interest in question is not deductible. The ineligible uses include:

— exempt income;

— life insurance policies;

— personal consumption; and

— making of capital gains.

Interest on borrowings used for NON-INCOME EARNING PURPOSES, SUCH AS THE MAKING OF CAPITAL GAINS, is not deductible:

Interest on borrowings used for non-income earning purposes, such as personal consumption or the making of capital gains is similarly not deductible. The statutory deduction thus requires a characterization of the use of borrowed money as between the eligible use of earning non-exempt income from a business or property and a variety of possible ineligible uses. [Bronfman Trust, supra, page 45 (C.T.C. 124; D.T.C. 5064)]

[Emphasis added.]

In my opinion, the distinction between eligible and ineligible uses of borrowed funds applies just as much to taxpayers who are corporations or trusts as it does to taxpayers who are natural persons. While it is true that corporations or trusts are less likely to be motivated by personal consumption purposes, THERE REMAINS NEVERTHELESS A VARIETY OF INELIGIBLE USES FOR BORROWED MONEY WHICH APPLY TO ARTIFICIAL PERSONS. A TRUST MAY, FOR EXAMPLE, PURCHASE ASSETS FOR THE PURPOSE OF CAPITAL GAIN. [Bronfman Trust, supra, page 46 (C.T.C. 125; D.T.C. 5064)]

[Emphasis added.]

It therefore follows from the above that if the intention of a taxpayer, even an artificial person, is to make money by making a capital gain, the interest borrowed [sic] will not be deductible.

The evidence in the instant case is extremely clear that the money borrowed was used to make a capital gain. The only realistic way for the appellants to make money was through the increase in value of the shares of the offshore" companies. We shall show this below.

In addition, very substantial capital gains amounts were realized both by Mr. Ludmer's children and by Ludco. It will also be noted that they were reported as such by the appellants.

5.04.2 The respondent referred, inter alia, to the following cases in support of his thesis:

1. Fallis

In Fallis v. M.N.R. (1966), 40 Tax A.B.C. 370, 66 D.T.C. 233, the appellant had borrowed a substantial sum at the rate of six per cent and seven per cent and invested the borrowed money in convertible securities of Trans-Canada Pipelines Ltd. bearing interest at5 /2 per cent. The tribunal found that what the appellant had in mind at the time of investing was the possibility of making a capital gain upon converting the securities (into shares) and thus found, in dismissing the appeal, that the appellant’s conduct was not consistent with his claim that the securities in question had been purchased as a source of income.

The appellant, Mr. Fallis, was a lawyer with a firm located on Bay Street, in Toronto. In particular, Mr. Fallis had income from his investments of $41,263.90 in 1960 and $51,648.08 in 1961, which was, it will be agreed, considerable for the time. However, Mr. Fallis had paid $52,440.65 in 1960 and $93,277.15 in 1961 in interest to a bank and to various brokers on the money borrowed in order to purchase the securities in question.

The Minister added $22,977.91 as investment income, the appellant having taken the position in his income tax returns that he had no income from property since the interest expenses exceeded his investment income.

The appellant, like Mr. Ludmer, was well informed about the stock market and had made numerous transactions over a long period of time in the said market. At the start of 1960, the appellant had been- particularly attracted by an issue of TransCanada Pipelines. It was an issue of debentures bearing interest at 5 /2 per cent and convertible into common shares.

He began his purchases of debentures in November 1960 and invested approximately $800,000. The conversion privilege was set at $15 per share after January 1, 1964. In 1960, it was too early to hope to convert the debentures into shares. Judge Fordham emphasized at the outset that the appellant must have known that the purchase of these debentures was destined to be a financial loss, at least until July 1,1964.

When the appellant bought the notes in question, two facts were evident after even a cursory perusal of the notes. One was that interest was payable on the notes at not more that 5 /2 per cent per annum. The other was that the notes were convertible after July 1, 1964, when shares of a par value of $15 each were obtainable. In the meantime, appellant committed himself to paying interest on borrowed money at rates varying from six per cent to seven per cent. Consequently, until the notes were converted, he could never hope to receive even as much interest as he paid on the loans that had enabled him to acquire the notes. A result was that throughout a period when no interest was received by the appellant, he was paying interest in respect of financial obligations that had nothing to do with the earning of income; the notes were not productive of any. An examination of the appellant's evidence leads me to conclude that what he had in mind was the ultimate conversion of his notes and the obtaining therefore of common shares that were expected to increase rapidly in value To convert notes into paid-up common shares hardly can be termed the producing of income; on the contrary, it was really a method of acquiring a capital gain. Once the shares had risen in value, the appellant would have been in a position to sell them at a substantial profit to himself, the shares reaching a market value of $44, or almost three times their original worth, not long after the time set for conversion.

The more one examines the transaction, the more it appears that the appellant had his eye on the benefits of conversion rather than on whatever interest might become payable under the notes. If this were not so, it is difficult to comprehend why he would pay out more interest than he could ever hope to receive. It is these facts and some of the answers given when he was cross- examined by Mr. Lefton, counsel for the respondent, that lead me to believe that the appellant was looking far ahead when he bought the notes and that a capital gain, rather than any income benefit, was what he had in mind. Consequently, I think that a part of the sum paid in satisfaction of interest accrued was not expended for the purpose of earning income, but for that of achieving a capital accretion in the form of paid-up common shares calculated to prove salable, later on, at a substantial profit. [pages 374-75 (D.T.C. 235-36)]

[Emphasis added.]

The evidence in the instant case presents the same characteristics. It was indeed upon redemption of the shares that the appellants expected to make their money, much more than on the nominal dividends paid annually. As Judge Fordham said in Fallis, if that was not the case, "it is difficult to comprehend why he would pay out more interest than he could ever hope to receive”. The purpose of the interest expense was therefore to promote capital accretion, not to earn income.

2. Moore

In Moore v. M.N.R., [1971] Tax A.B.C. 817, 71 D.T.C. 543, the same principle was followed in disallowing the deduction of an interest expense incurred by a taxpayer in respect of his investments in speculative mining shares. Commissioner Weldon, Q.C., wrote the following concerning what became paragraph 20(1)(c) [at page 824 (D.T.C. 548)]:

[Translation.]

4. As subparagraph 11(1)(c)(i) and (ii) of the Act should be interpreted, in my view, Parliament did not intend to provide a deduction from a taxpayer's income for interest paid on borrowed money where — as in the present matter

— the borrowed money was clearly obtained (in view of the nature of all but one of the stocks subsequently purchased by the present appellant, as indicated by the list set out earlier herein) with the intention of engaging in the buying and selling of mining stocks in order to profit by a rise or fall in their market value, i.e. for the purpose of making non-taxable capital gains in respect thereof.

[Emphasis added.]

The appellants also cite this case (pages 157 and 158 of the appellants' submission). They do not emphasize the passage which we cite. . . . In the citation which the appellants make, we draw the Court's attention to the fact that Judge Fordham [sic] wrote: ”. . . the definition of "invest" is to employ money in the purchase of anything from which interest or profit is expected" (page 158 of the appellant's submission). When one reads these excerpts together, this judgment wholly supports the respondent's claims: (1) a profit must be anticipated in order for the interest to be deductible; and (2) the money borrowed and used for the purpose of making a capital gain is not deductible.

3. Phoenix Overseas Operations Ltd.

In Phoenix Overseas Operations Ltd. v. M.N.R.,[1971] Tax A.B.C. 273, 71 D.T.C. 207, the tribunal also determined that the interest incurred by an investment company on money borrowed from a bank and relent at a slightly lower rate (after a period of six months without interest) to a member of a consortium of which the appellant was a member was not deductible. The decision reads as follows, at page 278 (D.T.C. 210):

[Translation.]

The appellant was free to make a loan at six per cent when it was paying interest at the rate of 3/4 of one per cent over the prime rate. It was also free not to charge the six per cent interest to the borrower for a period of 183 days. By doing so the appellant knew that a loss would be incurred on the borrowed capital.

4. Paramount Construction Co.

In Paramount Construction Co. v. M.N.R. (1963), 32 Tax A.B.C. 448, 63 D.T.C. 713, the appellant had borrowed money from a bank and lent the said amount to one of its subsidiaries at no interest. The Court determined that the Minister was correct in disallowing the deduction of interest paid to the bank since it did not meet the requirements set out in paragraph 20(1)(c).

5, Dockman

In Dockman v. M.N.R., [1990] 2 C.T.C. 2229, 90 D.T.C. 1804, the particular point for determination by the Court was whether interest could be deducted on a loan (“the second loan”). The taxpayer had borrowed the sum of $10,000 from the bank at a rate of 20 per cent interest and, under the agreement which he had reached with the person with whom he had lent [sic], the appellant was entitled to receive $11,000, including principal. Judge Brulé of the Tax Court of Canada dismissed the taxpayer's appeal concerning the deductibility of interest on this second loan [at page 2229 (D.T.C. 1805)]:

[Translation.]

The sole issue in this appeal is whether or not the interest paid on the borrowed sums was used for the purpose of gaining or producing income from a business or property within the meaning of paragraph 20(1)(c) of the Income Tax Act.

I will deal firstly with the right to deduct interest on the second loan of $10,000 made in August of 1982. In order to benefit from the deductions, a reasonable expectation of profit must be shown. In the case of this loan, the appellant borrowed funds from the bank at a rate of over 20 per cent. In return for this loan, the appellant was to receive a maximum of $11,000 including principal. Since the interest income portion of the repayment would be lower than the interest expense payable to the bank, the money borrowed was not being used for the purpose of earning income within the meaning of paragraph 20(1)(c) of the Income Tax Act.

An authority for not allowing the interest deduction on this second loan may be found in the case of Phoenix Overseas Operations Ltd. v. M.N.R., [1971] Tax A.B.C. 273, 71 D.T.C. 207 wherein the Court held that interest expense incurred by an investment company on money borrowed from the bank and reloaned at a lesser rate after a six-month interest-free period to a fellow member of a consortium was held not deductible.

[Emphasis added.]

The expression "for the purpose" obviously indicates that it is not necessary to show that income is generated by the property, but we claim that the taxpayer must show a bona fide intention in his actions that he has used the borrowed money for the purpose of earning income. (Dickson, J., Bronfman Trust, page 54 (C.T.C. 129; D.T.C. 5067): “It seems to me that, at the very least, the taxpayer must satisfy the Court that his or her bona fide purpose in using the funds was to earn income.")

The appellants’ dominant intention was to make a capital gain. The appellants also knew that they would receive token dividends or, as is popularly said, that that would represent "peanuts".

It is true, and we admit it without hesitation, that a taxpayer may do what he wishes with his money. It is certainly not up to the Minister of National Revenue to tell him what to invest in.

The taxpayer may choose to invest in property that does not produce taxable income: he has an absolute right to do so. In the instant case, however, a taxpayer must not expect taxation authorities to give him advantageous treatment, that is an interest deduction, since that would be contrary to the Income Tax Act.

On this subject, Dickson, J. wrote in Bronfman Trust:

[Translation.]

The taxpayer, of course, has a right to spend money in ways which cannot reasonably be expected to generate taxable income but if the taxpayer chooses to do so, he or she cannot expect any advantageous treatment by the tax assessor.

6. Arguments of the parties concerning subsection 9(3) of the Act

6.01 Appellants' argument concerning subsection 9(3) of the Act

6.01.1 Appellants' general argument

The appellants’ general presentation is submitted at paragraph 209 of the argument outline. It reads as follows:

209. The appellants further claim that subsection 9(3) I.T.A., which excludes capital gains from the definition of "income from a property”, is without consequence here since its purpose is only to prevent the deduction of interest in respect of loans used to purchase property which is not likely to generate income and which is not a trade good or bought and sold as part of a business or undertaking.

6.01.2 Appellants’ detailed argument

More specifically, at paragraphs 276 to 285 of his argument outline, counsel for the appellants supported his thesis as follows:

III. Subsection 9(3) I.T.A.

276. In Bronfman Trust, supra, Dickson, C.J. emphasized that the purpose of paragraph 20(1)(c) I.T.A. is to promote the accumulation of capital that produces income taxable in the investor's hands [at page 45 (C.T.C. 124; D.T.C. 5064)]:

[Translation.]

I agree with Marceau, J. as to the purpose of the interest deduction provision. Parliament created subparagraph 20(1)(c)(i), and made it operate notwithstanding paragraph 18(1)(b), in order to encourage the accumulation of capital which would produce taxable income. [12]

277. The appellants claim that the objective pursued by Parliament would never be achieved in the case of property that produces income if the interpretation of paragraph 20(1)(c) I.T.A. proposed by the respondent was accepted, that is if every property the resale of which could result in the realization of a capital gain could not provide entitlement to the interest deduction.

278. The appellants claim that paragraph 20(1)(c) and subsection 9(3) I.T.A. must be interpreted in accordance with the objective sought by Parliament, that is to encourage the accumulation of capital that produces income.

279. According to the appellants, subsection 9(3) I.T.A. is specifically intended to prevent the deduction of interest in the case of a non-income-producing property held on account of capital, but in no way restricts the deduction of interest in the other cases. The following judgments illustrate the foregoing.

280. In The Queen v. Stirling, [1985] 1 C.T.C. 275, 85 D.T.C. 5199 (F.C.A.) (application for leave to appeal denied, [1985] 1 S.C.R. xiii), Pratte, J.A. determined that the interest on the unpaid portion of the purchase price of gold bullion could not be deducted in computing the capital gain resulting from the sale of that bullion. [At page 276 (D.T.C. 5200):]

[Translation.]

In deciding that those interest and charges could be deducted, the learned trial judge did not rely on any provision of the Income Tax Act but, rather, on what, in his view, would have been the intention of Parliament had it given consideration to that question. We cannot agree with that approach.

In trying to support that judgment, counsel for the respondent argued in substance that capital gain should be computed according to the same rules as income from a business or property. That argument, while attractive, does not find any support in the Income Tax Act, which provides special rules for the computation of capital gain. Under those rules, as they are found in subparagraph 40(1)(c)(i) and section 54, the interest and safe keeping charges here in question could be deductible only if they were part of the cost of the bullion. In our opinion, they were not. As we understand it, the word "cost" in those sections means the price that the taxpayer gave up in order to get the asset; it does not include any expense that he may have incurred in order to put himself in a position to pay that price or to keep the property afterwards.

281. In Hastings v. M.N.R., [1988] 2 C.T.C. 2001, 88 D.T.C. 1391 (T.C.C.), a taxpayer had reported profits realized in commodities transactions as a capital gain, and he claimed a deduction of the interest on the money borrowed to purchase those commodities, under paragraph 20(1)(c) I.T.A. Judge Goetz disallowed the interest deduction [at page 2002 (D.T.C. 1392)]:

[Translation.]

In substance, the position of the Crown is correct in saying that the ordinary rules relating to expenses being deducted in the income earning process, do not apply to the capital gain sections. As has been mentioned in argument, there is a dividing line there when capital gains were introduced into the Income Tax Act in 1971 and there does not seem to be a bridge between the ordinary deduction process and the capital gains sections.

For those reasons, I must dismiss the appeal.

282. In Irrigation Industries Ltd. v. M.N.R., supra, Martland, J. emphasized that any purchaser of corporate shares normally has the implicit intention of disposing of them if they appreciate to the point where it is appropriate to sell them and that, on this basis alone, one cannot determine whether the profit arising from the disposition of the shares is business income or a capital gain. [At page 352 (C.T.C. 221; D.T.C. 1133-34):]

[Translation.]

Corporate shares are in a different position because they constitute something the purchase of which is, in itself, an investment. They are not, in themselves, articles of commerce, but represent an interest in a corporation which is itself created for the purpose of doing business. Their acquisition is a well- recognized method of investing capital in a business enterprise.

This point is made by Lord Normand in Commissioners of Inland Revenue v. Fraser (1942), 24 Tax Cas. 498, at page 502:

There was much discussion as to the criterion which the Court should apply. I doubt if it would be possible to formulate a single criterion. I said in a case which we decided only yesterday that one important factor may be the person who enters into the transaction. . . . It is in general more easy to hold that a single transaction entered into by an individual in the line of his own trade (although not part and parcel of his ordinary business) is an adventure in the nature of trade than to hold that a transaction entered into by an individual outside the line of his own trade or occupation is an adventure in the nature of trade. But what is a good deal more important is the nature of the transaction with reference to the commodity dealt in. The individual who enters into a purchase of an article or commodity may have in view the resale of it at a profit, and yet it may be that that is not the only purpose for which he purchased the article or the commodity, nor the only purpose to which he might turn it if favourable opportunity of sale does not occur. In some cases the purchase of a picture has been given as an illustration. An amateur may purchase a picture with a view to its resale at a profit, and yet he may recognize at the time or afterwards that the possession of the picture will give him aesthetic enjoyment if he is unable ultimately, or at his chosen time, to realise it at a profit. A man may purchase stocks and shares with a view to selling them at an early date at a profit, but, if he does so, he is purchasing something which is itself an investment, a potential source of revenue to him while he holds it.

283. The appellants in the instant case used the borrowed funds to purchase shares which produced dividends, as well as a profit on their disposition, which was reported as a capital gain.

284. The appellants respectfully claim that subsection 9(3) I.T.A. cannot in such a case have the effect of preventing the deductibility of interest.

285. For these reasons, the appellants claim that the interest expenses were deductible under paragraph 20(1)(c) I.T.A.

6.02 Respondent's argument concerning subsection 9(3) of the Act

Counsel for the appellants invite the court, by the thesis which they advance in law, to commit the same error of law as was committed by Thurlow, J.A., who delivered judgment on behalf of the Federal Court of Appeal in Bronfman Trust, which was set aside by an unanimous decision of the Supreme Court.

On this point, the appellants state:

According to the appellants, subsection 9(3) I.T.A. is specifically intended to prevent the deduction of interest in the case of a non-income-producing property held on account of capital, but in no way restricts the deduction of interest in the other cases. The following judgments illustrate the foregoing. (Page 224 of appellants’ submission.)

The appellants then cite, in particular, The Queen v. Stirling, [1985] 1 C.T.C. 275, 85 D.T.C. 5199 (F.C.A.), and Hastings v. M.N.R., [1988] 2 C.T.C. 2001, 88 D.T.C. 1391 (T.C.C.). These two judgments, in the respondent's view, are of no interest for the purposes of the instant action. In both cases, the point for determination was what constituted the" cost” of a property for the purposes of computing the capital gain under sections [sic] 54 and 40(1)(c)(i).

Where the appellants err in law, in the respondent's view, is where they claim that subsection 9(3) "is specifically intended to prevent the deduction of interest in the case of a non-income-producing property held on account of capital, but in no way restricts the deduction of interest in the other cases.” (Page 224 of appellants’ submission)

There is a clear error in law here since the facts in Bronfman Trust were precisely that the trust had decided to retain shares which were dividend-bearing, but on which the amount of the dividends was negligible compared to the interest paid in order to produce the dividend income. Those were precisely the facts, and the Supreme Court found that the interest paid was not deductible.

Let us recall what the Chief Justice of Canada said at that time [at page 45 (C.T.C. 124; D.T.C. 5064)]:

[Translation.]

Interest on borrowings used for non-income earning purposes, such as personal consumption or the making of capital gains is similarly not deductible. The statutory deduction thus requires a characterization of the use of borrowed money as between the eligible use of earning non-exempt income from a business or property and a variety of possible ineligible uses. The onus is on the taxpayer to trace the borrowed funds to an identifiable use which triggers the deduction.

[Emphasis added.]

To support their argument, the appellants further contend [at pages 226 and 227 of their submission] that:

In the instant case, the appellants used the borrowed funds to purchase shares which produced dividends, as well as a profit on their disposition, which was reported as a capital gain.

[Emphasis added.]

The respondent contends that the shares purchased produced negligible dividends compared to the interest paid in order to generate them.

Dividends:	$0.6 million
Interest:	$6.1 million
	[See R-57 and R-58.]

At no time did the appellants receive a profit, that is a surplus of dividend income over interest paid. No such possibility was foreseeable in any case, as we shall see below.

When the appellants speak of shares which produced dividends, as well as a profit on their disposition" [emphasis added], there is a carelessness in the use of words or an error in law.

Shares produce dividends, as real estate produces rent [sic]. Shares may increase in value, as may real estate. It is certainly not taxable income, much less a profit in law. It is otiose to recall here that a profit is the surplus of income (dividends) over expenses (interest).

7. Court's determination concerning the interpretation of subsection 9(3) and paragraph 20(1)(c) of the Act

As the capital gains nature of the profit resulting from the disposition of the shares of Justinian and Augustus is not in issue, it is important first to determine the true meaning of subsection 9(3) of the Act and then to apply it or not to apply it to the instant case through paragraph 20(1)(c).

7.01 Interpretation of subsection 9(3) of the Act

We shall cite again this provision, which defines the expression “income from a property":

9(3) Gains and losses not included.— In this Act, “income from a property" does not include any capital gain from the disposition of that property and "loss from a property" does not include any capital loss from the disposition of that property.

Interpreting this provision is very important in the instant case, not only because the net income from the disposition of the shares of Justinian and Augustus was reported as a capital gain (otherwise there would be no case) and allowed as such by the respondent, but mainly because interest is deductible under paragraph 20(1)(c) if the borrowed money was used for the purpose of "earning income from a business or property . . . .”

Notwithstanding the appellants’ interesting arguments cited above (6.01.1, paragraph 209 and 6.01.2, paragraphs 276 to 285), in the final analysis, the Court can only return to the following statutory provision:

. . .income from a property" does not include any capital gain from the disposition of that property. . . .

[Emphasis added.]

Thus, in order to compute the income from a property, one cannot take into account the capital gain resulting from its disposition. One must therefore take into account only the income, if any, from the property when the taxpayer had it in its possession. Thus, in the case of a taxpayer who borrows in order to build a plant that will be used in the operation of a business, one must consider the income that that plant will generate, not the profit which may result from the sale of that plant in 20 or 30 years. The plant is therefore income-producing capital. The same is true of the purchase of machinery, apartment buildings and the land on which they are built, etc.

Faced with such a clear provision as subsection 9(3), one cannot ask what Parliament's intention was. One must instead search among the arguments that contradict the obvious nature of this provision for approaches that may have led to a contradiction with the provision.

7.02 Interpretation of paragraph 20(1)(c)

7.02.1 We cite this paragraph again:

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 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 (other than borrowed money used to acquire property the income from which would be exempt or to acquire a life insurance policy), or a reasonable amount in respect thereof, whichever is the lesser;

7.02.2 Let us eliminate from this paragraph the parts that are not involved in the resolution of the point at issue.

(a) First, the last line of the provision beginning with "or a reasonable amount. . . ."

This concerns the case in which the rate of interest paid on a loan is too high. For example, the loan could come from a person not at arm's length, that is a shareholder of the company. The bank’s rate of interest could be considered as reasonable.

(b) Another part of the paragraph is the general introduction to 20(1) stating the necessity of the existence of the source of income at the time the deduction is claimed. This part is not in issue either.

(c) Neither the payment of interest,

(d) nor the legal obligation to pay it on a loan are under discussion either.

(e) It is admitted, lastly, that the borrowed money was not used to purchase a property from which income would be tax exempt or in order to purchase a life insurance policy.

7.02.3 The only provision remaining to be interpreted is thus the following, that is whether the borrowed money was "used for the purpose of earning income from a . . . property".

Based on the above interpretation of subsection 9(3), let us ask whether the property purchased with the borrowed money, that is the shares of Justinian and Augustus, generated income while they were held by the appellants. To this end, we should first cite subsection 9(1), which provides the definition of "income from property":

9(1) Subject to this Part, a taxpayer's income for a taxation year from a business or property is his profit therefrom for the year.

The word “ profit” is not defined in the Act. Its common meaning should therefore be attributed to it, that is the difference between income from property and the expenses pertaining thereto.

Income in the case of corporate shares consists of dividends, and the interest on borrowed money may be applied against that income.

7.02.4 It is important to reproduce Mr. Irving Ludmer's testimony in examination in chief concerning the borrowings, interest paid and foreseeable dividends:

Q. In this decision to invest, did you factor in the fact that you were borrowing money?

A. Absolutely.

Q. Would you tell the Court how that impacted on your decision to make this investment?

A. Yes, well when you borrow money, you leverage, as it's known, in order to make an investment. It was sort of like buying a stock on margin which is really what this is. You're buying stock at Bell Canada for example, you buy it on margin so that's called leverage. And essentially I made the decision to do so because I believed that the earnings would exceed the cost of money.

And that's when you leverage.

Q. The earnings from the shares?

A. The earnings from dividends and the share disposition at the end would exceed the cost of funds. It’s the same thing that I've done all my life in the real estate business. If I take the mortgage, the purpose of taking the mortgage would become stupid if I didn't think that I was going to be able to earn more money when I had to pay the banks. I’d have to be pretty stupid, I don't know how you can win doing that.

So essentially, it's what's known as leverage and I l felt that the leverage would be positive and that’s why we borrowed. Now, in this particular case we left a certain amount of equity where such that if that thing dipped, the bank wouldn't call the stock the first day. And that’s something that you don’t want to happen to you so you put in some equity and the rest is leverage. And you go from there.

And so I thought that while leverage increases risks, I thought that it was a good risk to take.

Q. I assume and as we'll see in a moment, I assume that you received some dividends from these shares?

A. I'd have to look it up, I think we did yes.

Q. Did the cost of borrowing that money exceed that dividend?

A. Oh certainly yes, it did.

Q. And was that a factor which also, or that you also considered in making the decision to invest?

A. Well of course, I mean. . . .

Q. And how did it impact on it, sir?

A. Well it impacts on it in the sense that you have to pay the banks I mean, they have a habit that if you don’t pay them they are not very happy. So they take away the stock and that's goodbye investment. So essentially you have to have sources of income to cover off the difference between any dividend and what you owe the banks on a current basis. And if you don't have the means, then you don't step up to the plate and you don't play, it's as simple as that.

So in this particular case this was obviously not the only revenue that the children would have. And they would have to be able to fund the shortage in cash flow should there be, let's say there were losses I mean, there would be no dividends.

So how are they going to pay the banks, they would have to have other income to the extent there was a dividend well, they needed that much less to pay the banks. So they had to have other income.

Q. Mr. Ludmer, as a point of fact in year one or even in subsequent years, did the dividends exceed the cost of borrowing the money for shares?

A. In no year did the dividends exceed the cost of money.

Q. And what was the impact of that, sir, in your decision?

A. Well that's you know, that's no different than for example, supposing I wanted to buy Place Ville Marie, I’m giving you an example. . . .

Q. Hypothetical?

A. Hypothetical, yes. Because you know, maybe I don’t have the money to buy Place Ville Marie but let's use that as an example. And let's say that the cost of money today at the banks is 14-3/4 per cent prime. So for round numbers let's say we'd have to pay 15 per cent and let's assume that the best that I could ever get ina rendement today, a return in acquiring a piece of property in the status of a Place Ville Marie is probably about 6-1/2 per cent.

And so I would have negative cash flow and so you say:"Well, listen if Ludco" being the company which would be doing the buying" doesn't have other income, forget about it.” I mean it’s a bankruptcy they won. So you have to have other cash flow.

Now what you’re doing it for is you're hoping that you're going to get a growth in the revenues and you're also going to be able as that growth in the revenues adds to the value of the asset, you’re going to be able to also sell the asset one day for a profit. So that’s why you leverage even if you don't conver [sic] through current income the cost of the money.

Examination of I. Ludmer, transcript of July 4, 1990, pages 159-64.

7.02.5 In cross-examination, Mr. Ludmer testified as follows:

Q. Did you ever expect that the dividends from Augustus and Justinian would cover your interest expense?

A. No, I didn't expect that the dividends would cover my interest expense and in any investment that I have made in real estate or stocks, subsequent, I never expected that either.

Cross-examination of I. Ludmer, transcript of November 19, 1990, page 203

7.02.6 This testimony of Mr. Ludmer clearly shows that the income from the shares of Justinian and Augustus could not yield a profit, and that that was not the end sought either. As he said, it was on all the dividend income and the capital gain on disposition of the shares that he expected to earn a profit.

However, the capital gain in the instant case cannot be taken into consideration because of subsection 9(3). Counsel for the appellants spoke of the "intrinsic profitability” [translation] (No. 77 cited at paragraph 4.03.4(7.2)) under the head "(f) Tax considerations” [translation]. This intrinsic profitability must meet the conditions of the tax statute, and the latter removes capital gains from the notion of income. It therefore remains that $6.1 million in interest must be deducted against dividends of $0.6 million, which equals losses of $5.5 million over the years as a whole. From this viewpoint, there could not have been any reasonable expectation of profit as per Moldowan v. The Queen, [1978] 1 1S.C.R. 480, [1977] C.T.C. 310, 77 D.T.C. 5213. And this is not only a question of mathematical computation over two or three years, but rather a long-term projection, as Mr. Ludmer's testimony showed.

7.02.7 Mr. Ludmer's testimony also demonstrated his skills in the field of high finance.

In this area, furthermore, he was even able to give the opinion which he had held in 1977 concerning the 300 stocks of the TSE 300 ("The TSE 300 Composite Index System") of the Toronto Stock Exchange (Exhibit A-159(h)). Mr. Ludmer had determined those that were blue chips and those that were not. Mr. Irving Ludmer's experience and skills were also demonstrated throughout his long testimony (4.03.4).

There can be no doubt that, starting in 1977, and then subsequently, Mr. Ludmer envisaged the purchase of shares of Justinian and Augustus for the appellants as an investment whose profitability would only be achieved on the day of disposition of the said shares.

7.02.8 In concluding on this point, I would like to cite Bronfman Trust, supra, in order to confirm my determination as consistent with the principles put forward by the Supreme Court [at page 45 (C.T.C. 124; D.T.C. 5064)]:

I agree with Marceau, J. as to the purpose of the interest deduction provision. Parliament created subparagraph 20(1)(c)(i), and made it operate notwithstanding paragraph 18(1)(b), in order to encourage the accumulation of capital which would produce taxable income.

[Emphasis added.]

Dickson, J. also added on this subject [at pages 53-54 (C.T.C. 129; D.T.C. 5067)]:

In my view, the text of the Act requires tracing the use of borrowed funds to a specific eligible use, its obviously restricted purpose being the encouragement of taxpayers to augment their income-producing potential.

At pages 45-46 (C.T.C. 124-125; D.T.C. 5064), the Court stated the following concerning, inter alia, the realization of capital gains and the borrowings used for non-income-producing purposes:

Interest on borrowings used for non-income earning purposes, such as personal consumption or the making of capital gains is similarly not deductible. The statutory deduction thus requires a characterization of the use of borrowed money as between the eligible use of earning non-exempt income from a business or property and a variety of possible ineligible uses.

In my opinion, the distinction between eligible and ineligible uses of borrowed funds applies just as much to taxpayers who are corporations or trusts as it does to taxpayers who are natural persons. While it is true that corporations or trusts are less likely to be motivated by personal consumption purposes, there remains nevertheless a variety of ineligible uses for borrowed money which apply to artificial persons. A trust may, for example, purchase assets for the purpose of capital gain.

[Emphasis added.]

8. Arbitrary, discriminatory, unfair, "retroactive" assessments?

The appellants’ alternative argument is that, even if the Court came to the conclusion that the reassessments in issue were correct, the appeals should nevertheless be allowed. Contrary to general principles arising from the case law (8.01), the reassessments issued are arbitrary (8.02), discriminatory (8.03) and unfair (8.04). Furthermore, according to the appellants, the respondent ignored the doctrine of estoppel (8.05) and, lastly, retroactively changed the established policy concerning the deductibility of interest (8.06).

8.01 Paragraphs 301 and following of the appellants’ argument outline begin with a presentation of the general principles that arise from the case law and which may be summed up as follows:

301. The courts have determined on a number of occasions that the government may not exercise the powers conferred upon it by the Act by relying on considerations foreign to the Act or in acting in an arbitrary or discriminatory manner.

(a) In Pioneer Laundry and Dry Cleaners Ltd. v. M.N.R., [1939] 4 D.L.R. 481, [1938-39] C.T.C. 411 (P.C.), Lord Thankerton set aside an assessment disallowing a capital cost allowance for improper grounds:

[Translation.]

Their Lordships agree with the Chief Justice and Davis, J. that the reason given for the decision was not a proper ground for the exercise of the Minister's discretion. . . .

(b) In M.N.R. v. Wrights’ Canadian Ropes Ltd., [1947] C.T.C. 1, 2 D.T.C. 927 (P.C.), Lord Greene indicated that the Minister of Revenue must not exercise the powers conferred on him in an arbitrary or fanciful manner [at page 14 (D.T.C. 931)]:

[Translation.]

But the power given to the Minister is not an arbitrary one to be exercised according to his fancy. To quote the language of Lord Halsbury in Sharp v. Wakefield, [1891] A.C. 173 at page 179 he must act "according to the rules of reason and justice, not according to private opinion; according to law and not humour. It is to be not arbitrary, vague and fanciful, but legal and regular". regular”.

[Emphasis added.]

(c) In D.R. Fraser & Co. v. M.N.R., [1949] A.C. 24, [1948] 2 W.W.R. 1119 (P.C.), Lord MacMillan wrote [at page 36 (W.W.R. 1127)]:

[Translation.]

The criteria by which the exercise of a statutory discretion must be judged has been decided in many authoritative cases and it is well settled that if the discretion has been exercised bona fide, uninfluenced by irrelevant considerations and not arbitrarily or illegally, no court is entitled to interfere even if the court, had the discretion been theirs, might have exercised it otherwise.

(d) In Prince George (City) v. Payne, [1978] 1 S.C.R. 458, 75 D.L.R. (3d) 1, Dickson, J., then puisne judge, determined that an organization exercising discretionary power may not base its decision on an extraneous ground or act arbitrarily with respect to certain individuals [at page 463 (D.L.R. 4)]:

[Translation.]

It is not a judicial exercise of discretion to rest decision upon an extraneous ground. The common law right of the individual freely to carry on his business and use his property can be taken away only by statute in plain language or by necessary implication.

(e) In Maple Lodge Farms v. Canada, [1982] 2 S.C.R. 2, 137 D.L.R. (3d) 558, Mcintyre, J. wrote [at pages 7-8 (D.L.R. 562)]:

[Translation.]

Where the statutory discretion has been exercised in good faith and, where required, in accordance with the principles of natural justice, and where reliance has not been placed upon considerations irrelevant or extraneous to the statutory purpose, the courts should not interfere.

(f) In Morin v. National SHU Review Committee, [1985] 1 F.C. 3, 46 C.R. (3d) 238 (C.A.), MacGuigan, J.A. [sic] wrote [at page 19 (C.R. 252)]:

[Translation.]

Unlawful behaviour by the Minister may be stated with sufficient accuracy for the purposes of the present appeal (and here I adopt the classification of Lord Parker, C.J., in the Divisional Court): (a) by an outright refusal to consider the relevant matter, or (b) by misdirecting himself in point of law, or

(c) by taking into account some wholly irrelevant or extraneous consideration, or (d) by wholly omitting to take into account a relevant consideration.

[Emphasis added.]

(g) In Gingras v. Canada, [1990] 2 F.C. 68, 69 D.L.R. (4th) 55 (F.C.T.D.), Dubé, J. wrote [at page 88 (D.L.R. 71)]:

[Translation.]

Canadian courts at all levels have repeatedly reaffirmed the interdependent criteria set forth in Padfield v. Minister of Agriculture, Fisheries and Food, [1968] A.C. 997. Like the House of Lords, they also have concluded that an administrative authority misuses its power when it acts for improper ends, other than those specified in the Act, or based on wrong principles or with reference to factors unrelated to the law and irrelevant, by failing to take relevant factors into account or in an arbitrary, unreasonable or discriminatory manner.

[Emphasis added.]

8.02 Referring to the evidence, counsel related the following facts to emphasize the extent to which the assessments were arbitrary:

311. At the relevant time, the deduction of the interest paid by the Canadian taxpayers to purchase shares in so-called "offshore" companies was not the real problem which the investment in those companies posed for the respondent.

312. In reality, the real problem posed for the respondent by the so-called "offshore" companies was the fact that the income generated by those companies was not taxable by the respondent, not that the interest expenses were deductible, as Calderwood admitted at the hearing:

[Translation.]

Q. And in final analysis, Mr. Calderwood, isn't it fair to say that there was, the perceived abuse by Revenue, at the time, was the fact that these companies were earning income in foreign jurisdictions and not paying any Canadian tax on that income?

A. That could be.

Q. That was really the real problem?

A. The real problem was the income. A subsidiary problem was the deduction of interest earnings.

Cross-examination of Calderwood, transcript of May 7, 1991, pages 267-68

313. The goal sought by the respondent in disallowing the deduction of interest on the borrowings used to purchase shares in the so-called "offshore" companies is clearly illustrated in the correspondence exchanged between respondent's officers on this subject:

[Translation.]

As you know, Ron Wilson has been working with Bob Brown of Price Waterhouse in Toronto to examine various approaches of attack on the offshore mutual fund problem. I have asked Ron to ensure that Real Bédard is brought into these deliberations.

The problem is, as you know, extremely complex and there is no easy, yet effective, solution. In my discussions with a number of the more responsible tax professionals, they have suggested that the deductibility of interest on funds borrowed to acquire an interest in many of the typical offshore funds is questionable at best, even when there is a possibility (almost always remote) of a cash dividend. They feel that the courts would be particularly sympathetic and that some bloom would go off offshore mutual funds if the word were out that Revenue Canada intends to challenge the interest deductibility. While this would not solve the problem—the possibility of deferring tax and of converting income into capital gains would remain attractive—the threat of an interest disallowance would certainly discourage a number of investors. I therefore encourage you to pursue disallowance while we attempt to come to grips with the conversion-deferral aspects of the problem.

[Exhibit A-205.]

314. The appellants claim that, on the pretext of disallowing the deduction of the interest paid for the share [sic] of their shares in Justinian and Augustus, the respondent was in fact only trying to discourage investments in such companies and that he did not disallow the deduction of that interest because the appellants did not, furthermore, meet the prerequisite conditions stated in paragraph 20(1)(c) I.T.A.

315. The appellant could not, on the pretext of disputing the deductibility of interest, try to solve the problem which he perceived at the time, that is the taxation of income generated by these so-called "offshore" companies, which problem was effectively solved by legislative amendment, that is enactment of section 94.1 I.T.A.

316. The respondent could not usurp Parliament's legislative function in this way by seeking by roundabout means to have sanctioned propositions which did not have force of law and to which Parliament in its wisdom had thought good not to give effect before 1986 (section 94.1 I.T.A.). Likewise, the respondent could not again usurp Parliament's legislative function by seeking, through its reassessments in 1986 and 1987, to give retroactive effect to Resolution 23 of the 1981 budget to which Parliament in its wisdom had deemed good not to give effect.

317. At all events, the respondent could not, in an arbitrary and discriminatory manner, select the appellants as investors of Justinian and Augustus as targets for the purpose of disallowing their interest expenses, when he authorized every other taxpayer investing in companies to deduct his interest expenses, even where the shares thus purchased did not or would not produce any income.

318. It is understood that, in the respondent's view, the only characteristic actually distinguishing Justinian and Augustus from companies such as Bell Canada was their'^offshore" characteristic. [13] In the appellants’ view, this characteristic alone was insufficient to justify the discrimination of which the appellants were clearly victims.

8.03 The appellants emphasized in particular the discrimination of which they claimed to be the object:

319. Furthermore, the respondent could not in an arbitrary and discriminatory manner select the appellants as the only target of a full-scale investigation and reassessments having for their purpose to disallow deductions claimed, when many other taxpayers who had invested in similar companies were not disturbed on this subject.

320. There were approximately 30 to 40 companies similar to Justinian and Augustus at Gutenplan's time.

Cross-examination of Gutenplan, transcript of May 7, 1991, pages 49-50.

321. Of those 30 to 40 companies, the only corporations concerned by the respondent's investigation were Justinian, Augustus and Spartacus, although the respondent knew of the existence of other similar corporations subject to the Winnipeg, Vancouver and Toronto district offices, for example. No other full-scale audit was undertaken against those other companies.

Examination of Burton, transcript of May 6, 1991, pages 45, 86-88. Re-examination of Burton, transcript of May 6, 1991, pages 118-20. Examination of Gutenplan, transcript of May 6, 1991, pages 141-43.

Cross-examination of Gutenplan, transcript of May 7, 1991, pages 50-67. Exhibit R-49, tab 22, pages 73-75.

Cross-examination of Calderwood, transcript of May 7, 1991, pages 236-44.

322. Demands were issued only against Ludco and another investor in Justinian, Augustus, Darius and Spartacus, against the Bank and the law and accounting firms that were associated therewith.

Examination of Gutenplan, transcript of May 7, 1991, pages 48-49,

Exhibit R-49, tabs 24 and 25 Cross-examination of Calderwood, transcript of May 7, 1991, pages 252-56.

Cross-examination of F.T., transcript of May 8, 1991, pages 169-72.

323. Ultimately, assessments disallowing the interest deduction for purchases of shares in the so-called "offshore" companies were issued only against the appellants and certain other unidentified investors in Justinian, Augustus, Darius and Spartacus.

324. The appellants therefore claim that they were treated in a discriminatory manner by the respondent relative to the other taxpayers who had purchased shares in the so-called "offshore" companies.

325. Lastly, the evidence shows that the respondent eventually gave instructions to his auditors to disallow the deduction of interest paid by the taxpayers in order to purchase shares of so-called "offshore" companies where the dividend paid in respect of those shares was “nominal” or token, without setting any standard enabling those auditors to determine what constituted a “nominal” or token dividend, which resulted in an arbitrary application of paragraph 20(1)(c) I.T.A. The deduction of interest claimed by the appellants was thus arbitrarily disallowed because the auditor Tirabasso was of the view that the dividends paid to the appellants by Justinian and Augustus were "token", even though he could not determine exactly in what token dividends consisted and had not tried to determine how the dividends paid by Justinian and Augustus compared with those paid at the time by other corporations and when the respondent's policy was to authorize the deductibility of interest for shares that paid no dividends.

326. The respondent could not allow the application of paragraph 20(1)(c) I.T.A. to be contingent on the arbitrariness, pure and simple, of the public servant responsible for the file by not providing that public servant with any standard of assessment, except a vague and imprecise concept that was nowhere defined, neither in the I.T.A. or in the respondent's directives, particularly for a question as important as that of interest deductibility which, if fairly and uniformly applied, was likely to have considerable impact.

327. Calderwood also wrote on this point:

[Translation.]

As you are aware, this problem of interest deductibility is not restricted solely to offshore companies but may involve all Canadian investors who use borrowed funds to purchase shares of any corporation.

Because of the importance of this matter, we ask that you treat our request on a priority basis.

Exhibit A-186, volume XIII, page 2393

328. The appellants claim that the reassessments issued by the respondent are unlawful and invalid because of this arbitrary and discriminatory application of paragraph 20(1)(c) I.T.A. in respect of them.

8.04 The respondent allegedly acted unfairly in issuing the assessments:

329. The appellants intend to show below that, having regard to his obligation to act fairly, to his own principles of fairness and to the principle of estoppel, the respondent could not issue reassessments against the appellants disallowing interest deductibility five years after conducting a full-scale audit of their affairs in respect of this question retroactive to the taxation years 1981 to 1985.

330. The appellants further intend to show that, according to the same principles, the respondent could not retroactively amend his interpretation of paragraph 20(1)(c) I.T.A. and issue reassessments against the appellants disallowing the deduction of interest which they had paid.

8.04.1 Obligation to act fairly

8.04.1(1) General principles

331. In recent years, the law has undergone remarkable changes with regard to the application of the principles of fairness to the government's activities.

332. The case law recognizes that an organization exercising administrative powers has the obligation to act fairly in respect of individuals, in both procedural and substantive terms. The extent of this obligation, which applies to the respondent in his relations with taxpayers, varies with the circumstances of each case.

(a) In Martineau v. Matsqui Institution Disciplinary Bd., [1980] 1 S.C.R. 602, 106 D.L.R. (3d) 385, Dickson, J., then puisne judge, wrote [at page 622 (D.L.R. 405)] :

[Translation.]

The authorities to which I have referred indicate that the application of a duty of fairness with procedural content does not depend upon proof of a judicial or quasi-judicial function. Even though the function is analytically administrative, courts may intervene in a suitable case.

(b) In Syndicat des employés de production du Québec et de l'Acadie v. Canada (Canadian Human Rights Commission), [1989] 2 S.C.R. 879, 62 D.L.R.

(4th) 385, Sopinka, J. emphasized that the obligation to act fairly is a standard

whose content varies with the circumstances [at pages 895-96 (D.L.R. 425)]:

[Translation.]

Both the rules of natural justice and the duty of fairness are variable standards. Their content will depend on the circumstances of the case, the statutory provisions and the nature of the matter to be decided. The distinction between them therefore becomes blurred as one approaches the lower end of the scale of judicial or quasi-judicial tribunals and the high end of the scale with respect to administrative or executive tribunals. Accordingly, the content of the rules to be followed by a tribunal is now not determined by attempting to classify them as judicial, quasi-judicial, administrative or executive. Instead, the Court decides the content of these rules by reference to all the circumstances under which the tribunal operates.

(c) In Knight v. Indian Head School Division No. 19, [1990] 1 S.C.R. 653, 69 D.L.R. (4th) 489, L'Heureux-Dubé, J.A., writing for the majority, mentioned that the concept of fairness lies at the root of our system of law [at page 683 (D.L.R. 510)]:

[Translation.]

Of course with this flexibility comes the inherent difficulty of differing notions of fairness amongst those called upon to determine if the duty to act fairly was complied with. Therefore it is necessary to temper assertions that the concept of fairness is a purely subjective one. Like the principles of fundamental justice in section 7 of the Canadian Charter of Rights and Freedoms, the concept of fairness is entrenched in the principles governing our legal system (R. v. Beare, [1988] 2 S.C.R. 387, 55 D.L.R. (4th) 481, at pages 402-03 (D.L.R. 492-93), per La Forest, J. for the Court), and the closeness of the administrative process to the judicial process should indicate how much of those governing principles should be imported into the realm of administrative decision making.

8.04.1(2) Principles of fairness stated by the respondent

337. The respondent has adopted his own principles of fairness, which are contained, inter alia, in Information Circular 75-7R3. In it, the respondent also acknowledges himself that he is bound by the results of a previous audit concerning a return for a given taxation year:

3. All pertinent aspects are studied to determine whether a return is to be

reassessed within the four-year limit. The Department will normally

(c) not reassess where the understatement of tax in the return for the year should have been apparent to the Department, considering the degree of examination and audit that the return received;

Circular 75-7R3, Exhibit A-187, volume XIII, page 2394, paragraph 3, at page 2395.

338. This policy statement, in the appellants’ view, constitutes an express acknowledgement by the respondent of a principle of fair administration of the I.T.A., to the effect that taxpayers are entitled to rely on the fact that the respondent will not issue a reassessment, notwithstanding the fact that the time limit has not yet elapsed, when the respondent should have realized the understatement of tax in his audit.

339. The purpose of this policy is to prevent taxpayers from being harmed by a decision of the respondent to issue a reassessment of aspects of a taxpayer's return which he should have realized, which is [sic] not attributable to them, even if this sudden change occurs within the time limit provided by the I.T.A. for issuing the reassessment.

8.04.1(3) Application of these principles according to the appellants

340. It is clear from the evidence as a whole that the material facts and the fundamental question raised by these appeals are substantially the same as those considered in detail by the respondent in 1979-81 at the time of his full-scale investigation.

Cross-examination of Tirabasso, transcript of May 8, 1991, pages 163-64.

Cross-examination of Mulligan, transcript of November 22, 1990, pages 239-40. Cross-examination of Calderwood, transcript of May 7, 1991, pages 258-59.

341. It is also understood that the respondent's investigation was long and detailed and specifically and principally designed to determine whether the interest expenses were deductible, and that the outcome of that investigation was that no adjustment was made to the interest expenses claimed and deducted by each of the appellants for the taxation year in issue because those expenses were deductible in the respondent's view, having regard to the facts, to the applicable principle of law and to the respondent's own policy on the matter.

342. Relying on this admission of the respondent that the interest expenses were deductible, the appellants planned their affairs, filed their income returns and deducted their interest expenses:

[Translation.]

Q. You were feeling what, sir?

A. Feeling that Revenue Canada had accepted the position that Mr. Verchere is stating here and I say that for two reasons: one, because of this letter and the paragraph that's underlined on page 2 and equally as importantly the fact that in the years that followed, I never heard another word from Revenue Canada about this whole matter. And so I would say if you put those two together, I would say it is I think a presumption that any reasonable person could make that Revenue Canada had decided to let this matter go insofar as, at least, Ludco and the Ludmer children were concerned.

Q. Would you now go Mr. Ludmer still at page 1258 to the second full paragraph, the five lines from the bottom, sir; did that also deal with your concerns?

A. Yes.

"As far as the interest deductibility" — if you follow me —"As far as the interest deductibility is concerned, this is a question for each stockholder but as a general rule, Revenue Canada’s position is that they do not intend to disallow interest deducted with respect to money borrowed to purchase stock in Justinian et al.”

Q. And in the documents which were turned over to Revenue, of which copies were made, were these expenses or these expense claimed shown, made apparent?

A. Absolutely, they were made apparent, they were reviewed and Revenue Canada was fully aware that the interest was being shown and being deducted. And the dividends that were received were also being shown and included in income, without a gross up.

Q. For the prior years, for 1980, 1979, 1978 years in which interest expenses were claimed, were you made aware of any proposed assessment by Revenue whereby these interest expenses would be disallowed?

A. Never.

Q. Were you aware of any assessment or reassessment whereby these interest expenses for those taxation years would be disallowed?

A. Never.

Q. And was the fact that there were no assessing action taken by Revenue in connection with these expenses for those years, a factor in your assessment, in your decision in 1981?

A. Well, I'll be very honest with you: to me this whole investment was no different than buying shares at Bell Canada with borrowed money. And so I didn't even know there was a problem and when it appeared that Revenue Canada felt there was a problem, then at that particular point in time I was certainly looking for an answer from the lawyers or from Revenue Canada, from anybody, to tell me if this thing, for whatever reason, was not in keeping with the rules of interest deductibility, then at least tell me. Don’t come in and do a whole big audit and then disappear.

And on top of that, if one were to go along, if one could put faith in what is being written here by a lawyer, a member of the Bar of Quebec, to the people who run Justinian and so on, that in fact his meetings with Mr. Rowe indicated the government agrees with him, and then there's no action taken for four years, then I find it very, very strange indeed. I find this whole thing very strange.

Examination of Ludmer, transcript of July 5, 1990, pages 161-62.

[Translation.]

Q. And what was the impact of these representations on your position, Mr. Ludmer?

A. Well the impact was to give me comfort that the position, as I had been

explained the position, was in fact acceptable to all parties concerned.

Q. And what were those positions, sir?

A. Those positions were that the interest would be deductible in keeping with the interest on funds borrowed to buy shares of any other company, Canadian or otherwise, as long as there was an intention to declare dividends and so there was, and secondly that on disposition, the profit would, unless circumstances dictated that the individual was a trader, give rise to capital gains.

Q. And how did that influence your business decision at the time, sir? How did these reassurances and representations from Revenue influence your business decision at the time, sir?

A. Well I wouldn't have gone into it had — let's be very honest about it I mean, there was no, I wasn't going into something in order to really take a terrible beating on it. And it's as simple as that.

Now you compound that with what happened in 1980 and then in '81 and you can see why I I feel very strongly about the matter and why I feel I am a very aggrieved citizen of this country at the moment.

Q. Now Mr. Ludmer, would you turn to Volume 7, sir, and I take it, Mr. Ludmer, these representations in 1978 and 1981 would have, at least, I mean, would have influenced your decision as to whether or not you would pursue this matter, is that your testimony?

A. Absolutely.

Q. And the options you had at the time were what, sir?

A. The options I had at the time were either to sell and get out of the thing, I mean even just had there been the threat of litigation, I mean litigation doesn't come cheap, as you know, Me Du Pont.

Transcript of July 5, 1990, pages 171-74.

Transcript of July 5, 1990, page 176.

See also pages 180-83.

343. The appellants were reasonably entitled to conclude that the question of the deductibility of their interest expenses had been allowed [sic] in 1980 and 1981.

344. Since 1980-81, the appellants have faithfully filed annual income tax returns for the taxation years 1981 to 1985 in which the interest expenses for the purchase of their shares in Justinian and Augustus were periodically claimed and deducted. Those returns were assessed by the respondent each taxation year, and the deductibility of those interest expenses was never disputed.

345. The appellants claim that, in 1986 and 1987, the respondent could not retroactively dispute expenses whose deductibility he had allowed, when he had led the appellants to understand that the interest expenses here in dispute were deductible, when the appellants had planned their affairs accordingly, and when neither the facts nor the applicable principles of law had changed in any material way.

346. In the appellants’ view, the respondent was bound by the findings of his full- scale investigation, which had mainly concerned the deductibility of the interest, and by his own principles of fairness, and this Honourable Court should give effect to the respondent's obligation to act fairly and not to disallow retroactively the deduction of those interest expenses, a fortiori when the deductibility of those expenses was and is consistent with the respondent's own policy.

347. The appellants claim that the retroactive effect of these reassessments issued in 1986 and 1987 for the taxation years 1981 to 1985 inclusive has in fact deprived the appellants of the option of reorganizing their affairs so as to minimize or avoid taxes and interest of more than $2 million which they have now had to incur as a result of the respondent's reassessments (not to mention the tax and interest amounts resulting from reassessments of Revenu Québec) and has forced them, on pain of paying these taxes and interest amounts, to incur the considerable cost of the process of so-called administrative appeal through objection and the costs of a proceeding which has resulted in ten hearing days before this Honourable Court and generated a considerable quantity of transcripts and documentary evidence (not to mention the present submission).

348. In the appellants’ view, a fair application of the I.T.A. must, a fortiori, ensure that the respondent cannot, five years after the fact and retroactively, dispute the validity of expenses whose deductibility he has allowed, and when that admission was also consistent with his policy concerning the deductibility of interest.

349. There is no difference in principle, in the appellants’ view, between this policy statement of the respondent mentioned above and the situation in which taxpayers are subject to a full-scale investigation at the end of which the respondent admits the validity of the deductibility of the expenses claimed in one or more given taxation years and in which, in a subsequent year, the facts and principles of aw being the same, the respondent seeks to reassess the taxpayers in order to dispute the deductibility of expenses already allowed, for the five (5) previous years and retroactively.

350. This was also the view of the Chief of Appeals, Montreal District Office, when, on May 29, 1987, he wrote:

1. Circular 75-7R3

The taxpayer is audited in 1980 and 1981 for the 1978 and 1979 returns. He draws our attention to the fact that nothing occurred between 1981 and 1985 and claims that the Department should not have assessed on the basis of paragraph 3(c) of the above-mentioned Circular.

In our view, we must allow the objection mainly because of point 1, which states that the taxpayer had already been audited on this subject, and a period of four years had elapsed without his being informed of new developments in this affair.

Exhibit A-196, volume XIII, page 2442.

Exhibit A-197, volume XIII, page 2446.

Exhibit A-198, volume XIII, page 2451.

Exhibit A-199, volume XIII, page 2456.

Examination of Joly, transcript of November 23, 1990, page 16.

351. This policy is all the more applicable since an unreasonable period has elapsed between the time the reassessments were issued and the moment the respondent became aware of the relevant facts of the question.

Me GUY DU PONT : You have indicated this morning, and you indicated in your report of May 1987, that the fact that four years had elapsed between the date of the end of the '81 audit and the date of the reassessments, that in itself, nothing had occurred during that four year period. Isn't this four year period unreasonable, if one is aware of the problem?

A. It is mentioned in that written document which is appended there that it was not reasonable.

Q. Is that what I asked you?

A. Which was written by Mr. Sauvé, which l signed.

Q. Correct? Do you agree with that?

A. Yes, yes, it's written there.

Re-examination of Joly, transcript of November 23, 1990, page 227. Examination of R.J., transcript of November 23, 1990, pages 30-31. Exhibit A-195, volume XIII, page 2441.

352. The appellants claim that there is nothing in the paragraph cited from the Information Circular which restricts this policy solely to the taxation year audited. At all events, in light of the modern version of the doctrine of fairness, the respondent could not, five years after the fact, reopen questions which he had thoroughly investigated and audited, when all the facts and principles of law are constant and the decision to allow the deductibility of the expenses was consistent with the respondent's established policy in such matters and that the reassessments have a retroactive effect.

353. For these reasons, the appellants claim that, when the respondent conducted a full-scale investigation of their affairs, as was the case here, he concluded that the interest expenses were deductible, that the appellants had annually made and filed income tax returns in which they deducted their interest expenses, that the appellants had been assessed by the respondent in accordance with their return and that the facts and rules of law are substantially the same, the respondent cannot, five years after the initial audit and in a retroactive manner, reassess the appellants, disallowing the expenses claimed and assessing considerable taxes and interest.

8.05 The appellants argued that the doctrine of estoppel must apply, that is that the respondent, as a result of all his actions, had to continue to apply the existing theory in issuing assessments. The appellants wrote as follows at paragraphs 354 to 360 of their argument outline:

Estoppel

354. The appellants claim that, by virtue of the principle of estoppel, the respondent could not legally issue reassessments denying them the deduction of interest paid in order to purchase shares of Justinian and Augustus in light of the full-scale audit that had been conducted on the question of the deductibility of the interest.

355. In R. v. Canadian Pacific Railway Co., [1930] Ex. C.R. 26, [1929] 2 D.L.R. 641, Audette, J. described the principles of estoppel as follows [at page 37 (D.L.R. 650)]:

[Translation.]

Estoppels in pais are called equitable estoppels because they arise upon facts which render their application in the protection of right, equitable and just. (2 Words and Phrases, 2nd series, pages 340 et seq.) Estoppel is the shield of justice interposed for the protection of those who have acted improvidently. It is the special grace of the Court, authorized and permitted to preserve equities that would otherwise be sacrificed.

356. In Robertson v. Minister of Pensions, [1949] 1 K.B. 227, [1948] 2 All E.R. 767, Lord Denning found that the doctrine of estoppel was binding on the Crown [at page 231 (All E.R. 770)]:

[Translation.]

The next question is whether the assurance in the War Office letter is binding on the Crown. The Crown cannot escape by saying that estoppels do not bind the Crown, for that doctrine has long been exploded. Nor can the Crown escape by praying in aid the doctrine of executive necessity, that is, the doctrine that the Crown cannot bind itself so as to fetter its future executive action.

357. The doctrine of estoppel was applied in The Queen v. Langille, [1977] C.T.C. 144, 77 D.T.C. 5086 (F.C.T.D.), in which Grant, D.J. found that the Minister of Revenue was bound by representations made to the taxpayer through an officer of the Department of Finance concerning the taxation of the principal of an annuity [at page 150 (D.T.C. 5090)]:

[Translation.]

The purchaser relied upon and acted upon such statements throughout. There is no suggestion that such saleslady did not herself believe such description to be true. . . . The principle of estoppel is binding on the Crown. The fact that the Crown's servant who sold the contract worked in a different department of the government does not affect this responsibility. (See Robertson v. Minister of Pensions, supra).

[Emphasis added.]

358. In Wilchar Construction Ltd. v. The Queen, [1981] C.T.C. 415, 81 D.T.C. 5318 (F.C.A.), Heald, J.A. stated the essential elements of an estoppel:

[Translation.]

The essential elements of an estoppel have often been stated as follows [at page 420 (D.T.C. 5321)]:

(1) a representation intended to induce a course of conduct on the part of the person to whom the representation is made;

(2) an act resulting from the representation by the person to whom the representation was made; and

(3) detriment to such person as a consequence of the act. (See Greenwood v. Martins Bank, [1933] A.C. 51. [See also Tricolor Prolab Ltd. v. M.N.R., [1990] 2 C.T.C. 370 (F.C.T.D.).]

359. The appellants claim that the essential elements in the application of the principle of estoppel are here present since:

(a) the respondent had represented to taxpayers in general, including the appellants, that no reassessment would be issued if he should have noted an underpayment of tax in a previous audit;

(b) the respondent conducted a full-scale audit in 1979 and 1981 of the appellants' affairs and of the question of deductibility of the interest which they claimed, and he was satisfied at that time that that interest was deductible under paragraph 20(1)(c) I.T.A. and of the respondent's administrative policy on the deduction of interest;

(c) the appellants, having observed that the respondent was satisfied following his audit that the interest which they had paid was deductible, continued to pay interest during subsequent years and to claim the interest deduction for the purpose of computing their income; and

(d) the appellants thus acted to their prejudice since the respondent eventually disallowed retroactively the deduction of interest claimed by the appellants and assessed them considerable taxes and interest.

360. The appellants therefore claim that, by virtue of the principle of estoppel, the respondent was precluded from issuing reassessments disallowing their interest deduction for the taxation years 1981 to 1985.

8.06 Addressing another aspect, the appellants argued that the respondent could not retroactively change the established policy, of which it had informed the appellants and the public, on deductibility of interest paid to purchase shares.

8.06.1 General principles

361. One of the principal applications of the principle of the obligation to act fairly in substantive terms concerns retroactive changes of interpretation or administrative policy. The courts have found on a number of occasions that the government must not give retroactive effect to a change in interpretation of the Act or of administrative practice.

362. In Québec (Sous-ministre du Revenu) v. Ciba-Geigy Canada Ltd., [1981] R.D.F.Q. 156 (C.A.), Bisson, J., then puisne judge, determined that Revenu Québec could not retroactively amend its interpretation of certain provisions of the Retail Sales Tax Act, R.S.Q., 1964, chapter 71, as amended [at page 159]:

Confining myself to the period ending in 1972, when the respondent was first informed of the new application of the Act, it remains for me to ask whether the appellant could impose a retroactive assessment as he in fact did.

The appellant had for many years applied the Act in a thoughtful and not unreasonable way. I emphasize that we are not here concerned with a case in which a tax was not collected out of mere inadvertence on the department's part. It is only a measure of justice for the taxpayer that, if the department changes its attitude, it should not do so retroactively.

In the presence of the ever-increasing force of the administrative apparatus of governments, it is important for the citizen to know that he can rely on the permanence of agreements offered him by the government in the context of the application of a statute until notice is given that an end will be put thereto.

In the instant case, the agreement on what was taxable and what was not was thought out, clear, distinct and precise. It was made in an open and straightforward manner.

The same procedure had to be followed in order to put an end to it, and, for my part, I am not prepared to sanction the retroactive effect which the appellant wished to give to the breaking of the agreement.

363. In Québec (Sous-ministre du Revenu) v. Transport Lessard (1976) Ltée, [1985] R.D. 502 (Q.C.A.), Nichols, J. delivered a similar judgment concerning another retroactive change given by Revenu Québec to the interpretation of certain provisions of the Retail Sales Tax Act, R.S.Q., 1964, chapter 71, as amended, relying on the principle of the obligation to act fairly [at pages 505-06):

The applicable principles in such cases are those which were derived by our Court in Sous-Ministre du Revenu du Québec v. Ciba-Geigy Canada Ltd., supra, which the first judge cited.

With the support of his colleagues, Turgeon and Lajoie, JJ., Bisson, J. wrote:

The appellant had for many years applied the Act in a thoughtful and not unreasonable way. I emphasize that we are not here concerned with a case in which a tax was not collected out of mere inadvertence on the department's part. It is only a measure of justice for the taxpayer that, if the department changes its attitude, it should not do so retroactively.

From this citation, I retain this sentence in particular: "It is only a measure of justice for the taxpayer that, if the department changes its attitude, it should not do so retroactively."

These remarks, in my view, convey the general obligation which the government has to act fairly (duty to act fairly).

Some claim that this duty of natural justice applies only to procedure, but there is no shortage of authorities to extend it to the content of government actions.

364. In Granger v. Canada (Employment and Immigration Commission), [1986] 3 F.C. 70, 29 D.L.R. (4th) 501 (F.C.A.), Pratte J.A., for the majority, found, at page 77 (D.L.R. 505), that Transport Lessard, supra, although it did not apply in that case, was "not beyond criticism” [translation]. It should be noted that the judgment of the Court of Appeal was affirmed by the Supreme Court, but on other grounds. However, in Bendahmane v. Canada (Minister of Employment and Immigration), [1989] 3 F.C. 16, 61 D.L.R. (4th) 313, the Federal Court of Appeal subsequently delivered a judgment diametrically opposed to Granger, supra, and there is therefore reason to believe that the comments expressed by Pratte, J.A. in Granger, supra, are now moot.

8.06.2 Respondent's policy on deduction of interest

365. During the period in issue and on the date of issue of the reassessments, the respondent's policy was to allow the deduction of an interest expense incurred for a loan used to purchase shares, even if the shareholder had no expectation of receiving any dividend:

[Translation.]

Q. Mr. Rowe, do you recall if at the time Revenue had a policy with respect to

interest deductibility for the purchase of common shares, generally?

A. As I recall the interest paid on money to acquire common shares was deductible.

Q. Alright. Whether or not there was an actual dividend being paid on the yearly basis, Sir?

A. Yes, as I recall, because, as an example, like mining shares never actually pay any dividend.

Q. And nevertheless, what was Revenue's position, sir, vis-à-vis interest deductibility for the purchase of such shares?

A. That it was deductible.

Q. Alright. And I take it, sir, that on the sale or redemption of those shares

taxpayer could claim a capital gain, such mining shares, for example?

A. Depending.

Q. First of all depending if there were a profit, assuming there's a profit?

A. Presuming the investor wasn't a trader dealing or a speculator, whatever, if it is a anormal investment and capital investment that would obviously be a capital gain.

Q. Alright. So at that even though he may not have any dividends during its holding of those shares?

A. That's right.

Q. So in one hand he would be allowed to deductibility of the interest and capital gain at the end. Is that basically how it would work?

A. Yes, under normal circumstances, yes.

Q. Thank you. Mr. Rowe, in paragraph four [of the] action to be taken, do I take it that the reference here to the memorandum of December 11, 1981 is a reference to the exhibit we saw at page 2384, which is Exhibit A-183, sir?

A. That's right.

Q. And would you turn to page 184, Sir?

A. To page, sorry?

Q. I'm sorry, Exhibit 184, page 2390. Before we deal with that, the policy you've referred to about interest deductibility for the purchase of common shares, and you gave an example as mining shares which paid no dividends, I take it it was not limited to mining shares, it applied to all common shares, generally?

A. Yes, generally to all.

Q. And was it also well known to the tax paying public that such was Revenue’s policy?

A. As far as I know, yes.

[Emphasis added.]

Examination of Rowe, transcript of November 22, 1990, pages 188-89, 192-94, 198.

366. The respondent allowed the interest expense deduction even for companies resident ana doing business abroad, such as Justinian and Augustus, but which, unlike the latter (v.g. "Casuarina"), did not or could never pay dividends:

[Translation.]

Q. Alright. And isn't the statement made, isn't that article served to the effect that these funds typically pay no dividends?

A. Correct.

Q. Annually, isn't that a fair statement describing most of these funds?

A. Correct.

Q. And is it not also fair to say that on your policy as it existed up to '84, interest to buy into these funds who paid no dividends would nevertheless be deductible?

A. They would be deductible or they may be deductible under 20(1)(c).

Q. Yes, according to your policy up to '84?

A. Correct.

Q. Even if these shares, even if these companies precluded any payment of dividends?

A. That's what the hot line question and answer indicates.

Re-examination of Burton, transcript of May 6, 1991, pages 115-16.

367. Burton explained the respondent's position as follows:

[Translation.]

Q. Alright. So, if I understand this Hot Line, Your Honour, A-203, if a taxpayer bought shares in a company that paid no taxable dividends, it could deduct the interest on the money used to pay and buy those shares, up to '84?

A. Yes.

Q. Alright. Even though there was no possibility or no expectation of that company paying any kind of taxable dividend?

A. That's what the question indicates.

Q. And the answer?

A. And the answer.

Examination of Burton, transcript of May 6, 1991, page 108.

368. Gutenplan explained, for his part, as follows:

[Translation.]

Q. Was it not Revenue's policy, at least up until 1981, sir, to the effect that a taxpayer could claim as a deduction interest paid to purchase shares that were precluded from paying taxable dividends?

A. On this document, it says yes.

Q. And isn't that, sir . . . the word "preclude" suggests that there is no possibility of paying taxable dividends?

A. Yes, they do.

Q. So, I take it then, Sir, that Revenue's policy at the time was to allow the interest deductions for the purchase of shares even though those shares were and would not or could not pay any taxable dividends?

A. According to this document, yes.

Cross-examination of Gutenplan, transcript of May 7, 1991, pages 140-41.

[Translation.]

Q. Fine. And is it not a fact, sir, that in 1976 up until, according to Mr. Burton was only in '84 that the answer to this question was changed?

A. That is what Mr. Burton stated.

Q. Yes. Alright, are you aware of any other change in connection with this answer to this question before 1984, sir?

A. No, I am not.

Cross-examination of Gutenplan, transcript of May 7, 1991, page 159.

369. Tirabasso, for his part, mentioned:

[Translation.]

Q. All right. Would you indicate to the Court, sir, what rate or what criteria or standard did you apply to determine if, in those situations where you were dealing with nominal . . . or let be backtrack.

Did you apply any comparison, did you make any comparison between the rate of return of a dividend and the money they were paying at the bank?

A. No.

Q. Why not?

A. In most circumstances that I remember auditing, shareholders would borrow money to invest in their own personal company which paid no dividends.

Q. And in those contexts, sir, would Revenue Canada allow the expense?

A. Yes, it would.

Q. Even though there was no dividend being paid?

A. We have a policy on that.

Q. And what was that policy, sir?

A. It's an interpretation bulletin, and don't ask me to go and . . . .

Q. In general terms, sir, what was the policy at the time?

A. If it’s incurred to earn income, we will allow it.

Q. All right. And in this context you have just described, of an individual borrowing money from the bank to invest in his own corporation, would Revenue Canada allow the interest expense?

A. In most circumstances, they would.

Q. Even though there were no dividends being paid?

A. Yes.

Q. That was the policy at the time of your reassessment, sir?

A. Yes.

Q. All right. And did you also encounter cases where investors had borrowed money to buy into publicly-traded corporations, sir, or buy shares of publicly- traded corporations?

A. Yes, there are.

Q. And did you also apply the same rule as to whether or not a determination would be made about the existence of a nominal dividend or not?

A. The rule was not the existence of a nominal dividend, it was the fact that the investment produces income.

Q. I see. And it was enough for the share to yield a dividend?

A. Basically speaking, that would be.

Q. All right. And is there a percentage over which the expense was allowable and under which the expense was not allowable?

A. No, there is no policy.

Q. So do I take it then, sir, it is left to the assessor's own determination whether it would be proper and appropriate in the circumstances?

A. With regards to?

Q. Deductibility of interest to buy into shares.

A. Buy into shares . . . the law is specific: it has to earn income following the law, it’s not up to the. . . .

Q. I'm talking about policy, sir.

A. The policy, I think it’s written in the IT bulletin.

Q. Okay. Would you go to exhibit A-203, sir. You’re familiar with the policy, are you, Mr. Tirabasso?

A. Yes.

Q. You're familiar [With] their outlines?

A. Yes, I am.

Q. And you're familiar with question and answer number one, sir?

A. The question number one: "Can a taxpayer claim as a deduction interest paid to purchase shares that are precluded from paying taxable dividends?" And the answer is yes.

Q. Is your understanding of "precluded", sir, meaning that the shares would not pay any dividends?

A. That's right, that’s what it means.

Q. Isn't my understanding then, sir, that according to this document Revenue's policy was to allow interest expense, even for shares for which there would be no dividend being paid or possibly paid, or potentially paid?

A. As of this date, it's dated February, 29,1976. . . .

Q. All right.

A. . . .this seems to be the answer.

Q. If you'd look to exhibit A-204, sir. . . I'm sorry, not 204. R-47, please.

HIS HONOUR: R-47?

Me GUY DU PONT: I'm sorry, Your Honour, yes.

Q. This document, sir, is '84?

A. Nineteen eighty-four.

"Can a taxpayer deduct interest in respect of funds used to purchase speculative stock?”, and the. . . .

Q. You notice that question number one has now disappeared as of '84.

A. Yes.

Q. So this policy was in force from 1976 up to and including 1984, or the date indicated in this document.

A. Yes.

Q. Do I take it then, sir, that Revenue Canada's policy at the time was to allow interest in shares which were precluded from paying any dividend to allow the interest expense on money borrowed to buy those shares? According to those documents, sir.

A. Well, according to this document, I must say yes.

Cross-examination of Tirabasso, transcript of May 8, 1991, pages 129-34.

370. This policy was in effect across the country and, in the view of the assessor Tirabasso, it was in effect at the time the reassessments were issued.

Re-examination of Tirabasso, transcript of May 8, 1991, pages 166-68.

371. The appellants claim that the respondent's administrative policy during the relevant period was to allow deductibility of interest paid to purchase shares, without regard to the payment of dividends on those shares. Under the terms of that policy, the appellants, who had received dividends on their shares of Justinian and Augustus, were entitled to deduct the interest paid for the purchase of those shares.

372. The appellants claim that, by virtue of his obligation to act fairly, the respondent had to comply with the administrative policy which he had established and of which he had informed the public with regard to the deductibility of interest paid in order to purchase shares.

373. This policy concerning the deductibility of interest for the purchase of shares was in effect throughout the relevant period and still applied at the time when the reassessments were issued and on the date of the hearing of the instant appeals.

374, The appellants claim that the respondent violated his obligation to act fairly by denying the appellants the deductibility of the interest on their share purchases [sic] contrary to his administrative policy, and that the reassessments issued for the purpose of disallowing that deduction are therefore invalid.

375. The appellants claim that if the respondent wished to amend his administrative policy, he should have done so for the future, not to give retroactive effect to such amendment.

9. Court's opinion on the various points raised by the appellants in paragraph 8 above

9.01 General principles and case law

The Court has nothing against the general principles stated in the case law cited by the appellants (8.01). All the points raised, that is discrimination, etc. (8.02 to 8.06) are circumstances surrounding the issue of an assessment and which cannot in principle vitiate it, except in very particular circumstances. It is mainly the outcome of the assessment that counts with regard to the legal provision involved and to Parliament's intention with respect to that provision.

As the Federal Court of Appeal stated in The Queen v. Consumers Gas Co., [1987] 1 C.T.C. 79, 87 D.T.C. 5008, at pages 83-84 (D.T.C. 5012):

[Translation.]

What is put in issue on an appeal to the courts under the Income Tax Act is the Minister’s assessment. While the word "assessment" can bear two constructions, as being either the process by which tax is assessed or the product of that assessment, it seems to me clear, from a reading of sections 152 to 177 of the Income Tax Act, that the word is there employed in the second sense only.

[Emphasis added.]

9.02 Assessments not arbitrary

According to the appellants (Nos. 311 to 318 of the appellants’ argument outline, at paragraph 8.02), the real problem was not the deduction of interest, but the fact that the so-called "offshore" companies were not taxable in Canada.

Under the guise of disallowing the interest deduction, the respondent sought to discourage the investments in those companies. This problem, which was one for Parliament, not for the respondent, was solved in 1986 by Parliament (section 94.1 I.T.A.). Whatever the underlying reasons that may be attributed to the respondent, the Court must consider only one thing, that is whether paragraph 20(1)(c) applies. On this point, the Exchequer Court clearly explained this principle in delivering judgment in M.N.R. v. Minden, [1962] C.T.C. 79, 62 D.T.C. 1044, at page 89 (D.T.C.1050):

[Translation.]

In considering an appeal from an income tax assessment the Court is concerned with the validity of the assessment, not the correctness of the reasons assigned by the Minister for making it. An assessment may be valid although the reason assigned by the Minister for making it may be erroneous. This has been abundantly established.

This decision was recently cited by the Federal Court of Appeal in The Queen v. Riendeau, [1991] 2 C.T.C. 64, 91 D.T.C. 5416.

It is appropriate to refer to Lumsden v. Commissioners of Inland Revenue, [1914] A.C. 877, in which Lord Parmoor wrote at page 924 of his judgment:

[Translation.]

In coming to a conclusion on this point the ordinary principles of construction must be followed. A statute is the expression of the will of the Legislature, and it is the duty of the Courts to give effect to the language in which the will of the Legislature has been expressed. It is not the function of Courts of law to entertain questions of policy, and I am unable to give any weight to arguments based on the consideration whether a particular interpretation is more favourable to the Crown or to the subject.

[Emphasis added.]

There is also Sutters v. Briggs, [1922] 1 A.C. 1, in which, after dismissing the appellant's appeal, Viscount Birkenhead offered the following comments, at page 8 of the judgment:

[Translation.]

The consequences of this view will no doubt be extremely inconvenient to many persons. But this is not a matter proper to influence the House unless in a doubtful case affording foothold for balanced speculations as to the probable intention of the legislature. Where, as here, the legal issues are not open to serious doubt our duty is to express a decision and leave the remedy (if one be resolved upon) to others.

[Emphasis added.]

In the instant case, the Court has ruled on the point whether the interest was incurred within the meaning of paragraph 20(1)(c). This is the point at issue.

The Court does not have to rule on another point once the statutory provision has been applied and the appeal is dismissed. It is the application of the section in issue which is the test of whether the reassessments are not arbitrary. The latter are not the result of a whim of the respondent.

9.03 Assessments not discriminatory

According to the appellants, the assessments were, inter alia, discriminatory because they were the only ones to be the target of a full-scale investigation. However, besides Justinian, Augustus and Spartacus, 30 to 40 similar corporations were not investigated (Nos. 319 to 328 of the appellants’ argument outline, cited at paragraph 8.03).

With regard to the investigations conducted by the Department of Revenue, the Supreme Court of Canada, in Western Minerals Ltd. v. M.N.R., [1962] S.C.R. 592, [1962] C.T.C. 270, 62 D.T.C. 1163, at page 596 (C.T.C. 273-74; D.T.C. 1165), adopted as its own the remarks made by the Exchequer Court in the Income Tax Act: Provincial Paper Ltd. v. M.N.R., [1954] C.T.C. 367, 54 D.T.C. 1199, and also reproduced the headnote of the latter ruling in its judgment:

[Translation.]

The conclusions reached in the first [Provincial Paper Ltd. v. M.N.R.] of the two cases and applied in the second are accurately stated in the headnote as follows:

Held: That it is not for the Court or anyone else to prescribe what the intensity of the examination of a taxpayer’s return in any given case should be. That is exclusively a matter for the Minister, acting through his appropriate officers, to decide.

2. That there is no standard in the Act or elsewhere, either express or implied, fixing the essential requirements of an assessment. It is exclusively for the Minister to decide how he should, in any given case, ascertain and fix the liability of a taxpayer. The extent of the investigation he should make, if any, is for him to decide.

3. That the Minister may properly decide to accept a taxpayer's income tax return as a correct statement of his taxable income and merely check the computations of tax in it and without any further examination or investigation fix his tax liability accordingly. If he does so it cannot be said that he has not made an assessment.

I am in agreement with these propositions.

With regard to the respondent's investigations in the instant case, it appears from Mr. Gutenplan's testimony that, at the time of his investigation, that is during 1980 and 1981, he knew of only four funds, that is Justinian, Augustus, Spartacus and Darius, even if, in light of information gathered, his report could apply to every other fund similar to the four funds considered (cross- examination of Mr. Gutenplan, transcript of May 7, 1991, pages 63-67).

Mr. Calderwood, Director, Tax Avoidance Division, testified that, in June 1984, at the time he issued communiqué No. TA-84-R-1 (Exhibit R-52) on the presentation concerning "investment funds in tax havens" [translation], there existed at least 15 companies of the same kind operating offshore. The witness also explained that he did not know how many Canadian investors that could represent, or how many had been the object of assessment measures, but that there existed a detection program within the Department of National Revenue (transcript of May 7,1991, pages 233-34).

Further on (at page 238), to the question "Why were these companies not investigated?" [translation], he answered as follows:

[Translation.]

Well, first of all, you have to have a taxpayer who's claiming the deduction. And unless you can identify the taxpayer, there's nothing you can serve a demand on.

Can it be concluded that the appellants were discriminated against because the only funds concerned by Mr. Gutenplan's investigation were the four funds in which the appellants had invested?

Can an automobile driver who has been chased because he drove through a red light argue discrimination because two other drivers who went through the red light at the same time as he and the police were unable to arrest them? To ask the question is to answer it. He does not complain that he was not treated like the other two, but complains that they were not treated as he was.

Furthermore, according to Mr. Gutenplan, he did not know of the existence of the appellant Ludco at the start of the investigation.

Lastly, in Canada v. McKinlay Transport Ltd., [1990] 1 S.C.R. 627, [1990] 2 C.T.C. 103, 90 D.T.C. 6243, the Supreme Court of Canada confirmed that the Minister of National Revenue has the power to audit the income tax returns of taxpayers at random and to involve the power to inspect records and obtain information from taxpayers under subsection 231(3) of the I.T.A. [at page 648 (C.T.C. 114; D.T.C. 6250)]:

[Translation.]

Accordingly, the Minister of National Revenue must be given broad powers in supervising this regulatory scheme to audit taxpayers' returns and inspect all records which may be relevant to the preparation of these returns. The Minister must be capable of exercising these powers whether or not he has reasonable grounds for believing that a particular taxpayer has breached the Act. Often it will be impossible to determine from the face of the return whether any impropriety has occurred in its preparation. A spot check or a system of random monitoring may be the only way in which the integrity of the tax system can be maintained. If this is the case, and I believe that it is, then it is evidence that the Hunter v. Southam Inc., [1984] 2 S.C.R. 145, 84 D.T.C. 6467, criteria are ill-suited to determine whether a seizure under subsection 231(3) of the Income Tax Act is reasonable.

Consequently, the Minister’s power to audit a taxpayer's income tax return at random does not constitute a discriminatory method.

The evidence also showed that the discrimination did not exist at the appeal stage, after the notices of objection were filed. The appeals service, according to its head, Mr. Joly, has a role independent of that of the audit service (transcript of November 23, 1991, pages 4-6).

9.04 Fair actions

It was mainly at the appeals level, however, that the appellants criticized the respondent for not having acted fairly (Nos. 331 to 353 of the appellants’ argument outline, cited above at paragraphs 8.04.1(1) to 8.04.1(3)).

9.04.1 They referred mainly to Information Circular No. 75-7R3(No. 337) and to the opinion given by the Chief of Appeals, Mr. Joly, on May 29, 1987, relying on that Circular (No. 350). That opinion favoured the appellants’ thesis, since Mr. Joly concluded in the following terms [in the transcript of November 23, 1990, page 30]:

In our view, we must allow the notice of objection . . . to the effect that the taxpayer had already been audited on this subject, and a period of four years had elapsed without his being informed of new developments in this affair.

Concerning this opinion demanded by the appellants, Mr. Joly explained that he had wanted to accommodate them through a referral to the office of the Deputy Minister, Mr. Robert D'Avignon. To do so, and for the office of Deputy Minister D'Avignon to be able to consider the question, Mr. Joly explained that he had to take a position in his request for referral to the Deputy Minister's office, even if he was not in fact in agreement with that position. In other words, to substantiate his request for referral to the Deputy Minister's office, Mr. Joly had to take a position contrary to the one he held (in the examination of Mr. Joly, transcript of November 23, 1990, pages 35-36):

But here we had a situation where Me Minzberg had made representations to my appeals officer in which he insisted that we go to Ottawa. He insisted that we go see Mr. D’Avignon. If I said no, Mr. Minzberg would go all the same. It was much easier for me to say yes, then the matter was resolved. Then in that way, we would perhaps be a little more expeditious, which is the primary purpose of notices of objection, that is to try to be expeditious, to provide service, and if we wanted to maintain, then we would maintain, then after that, it would go to a higher authority. Otherwise, we would delay, delay, delay.

So, when I signed that memo, I wasn't saying that it wasn't written, I wasn't saying that that was not my opinion, but I couldn't have another opinion because, if I had another opinion than that, then D'Avignon would have told me, "That's not logical, Réal; you have the power to maintain it; why are you coming to ask me? I delegated that authority to you”.

[Emphasis added.]

Mr. Joly also explained that, when the appellants demanded this opinion, they had already received an unfavourable reply from the Minister of National Revenue himself, the Honourable Perrin Beatty (letter of June 6, 1985, Exhibit A-47) and from the Deputy Minister, Mr. Harry Rogers (letter of March 11, 1986, Exhibit A-52).

9.04.2 Settlement offer to all

A settlement offer was made to the appellants (letter of April 15, 1985 to Ludco, Exhibit A-45, and letter of April 29,1985 to the individual appellants, Exhibit A-46), as it was submitted to other taxpayers in similar conditions.

This offer to the appellants addressed to Mr. Irving Ludmer consisted in substance (with certain distinctions), on the one hand, in considering the profit resulting from the sale of the shares as income and, on the other hand, in deducting the interest paid on the borrowings made to purchase the said shares. Mr. Irving Ludmer refused: “Well I was absolutely shocked." [Translation.] (Transcript of September 5, 1990, page 177.)

Even before the settlement offer and even before the assessments were issued, the appellants had already begun steps with the higher spheres of Revenue Canada. Mr. Ludmer was therefore already aware of the fact that Revenue Canada intended to disallow the interest [in the cross-examination of Mr. Calderwood, transcript of May 7, 1991, page 245]:

[Translation.]

The policy to deal with these matters was decided March of 1983 and that's when the meetings commenced with the taxpayers that we were aware of and were involved in such funds. And representations made by your firm caused the delays until February of '84 at which time we wrote to the four funds themselves to explain the Department's position.

It was at Mr. Irving Ludmer's request that Me Sam Minzberg drafted the letter addressed to the Honourable Perrin Beatty dated February 1, 1985, requesting a meeting with Revenue Canada representatives to discuss the Spartacus fund. As the president of Steinberg, Mr. Ludmer must certainly have been aware. The Spartacus fund had been formed for a specific clientele, that is Steinberg employees only (Exhibit R-49, tab 28).

The two-year period elapsed between the position taken by Revenue Canada in 1983 and the submission of the settlement offer to the appellants in 1985 was solely due to the appellants’ negotiations with Revenue Canada representatives. That is what arises from the testimony of Mr. Lyall Mulligan, an officer employed by Revenue Canada, Tax Avoidance Section (cross- examination of Mr. Mulligan, transcript of November 22, 1990, pages 241-244; cross-examination of Mr. Calderwood, transcript of May 7, 1991, page 245; examination of Mr. Joly, transcript of November 23, 1990, pages 129-133).

9.04.3 Mr. Irving Ludmer specified that what had motivated him to pursue the investments in Justinian and Augustus was the request for advance ruling with respect to Spartacus (the Steinberg employees' fund) and the letter of Me Bruce Verchère addressed to Mr. J.D. Frizzell, president of Justinian Corporation. These two documents therefore take on considerable importance in the proceeding. The request for advance ruling (Exhibit A-37, page 1243 ff.) was addressed to the respondent by Me Bruce Verchère on February 23, 1978.

The request for advance ruling with respect to Spartacus was subsequently withdrawn on an undetermined date. This undisputed fact appears at the start of a letter from the respondent (Exhibit A-39, page 1252 ff.) addressed to Me Verchére on May 3, 1978. That letter also states an opinion under certain basic principles pertaining to the deduction of interest. That letter reads as follows:

[Translation.]

Dear Sirs:

Re: Steinberg Inc. and Certain Key Employees

By letter of April 24, 1978 we acknowledged the withdrawal of your request for an advance income tax ruling in respect of some investment transactions contemplated by certain key employees of Steinberg Inc.

Pursuant to your letter of April 27, 1978 we now confirm several basic principles governing the deduction of interest expenditures in the computation of a taxpayer's income for a taxation year from a business or property.

1. Reasonable interest paid pursuant to a legal obligation on amounts borrowed to acquire foreign securities (corporate shares) will be deductible in computing a Canadian taxpayer's income provided the securities comprise property acquired for the purpose of earning income which is not exempt under the provisions of the Income Tax Act.

2. The deduction of such interest is not limited to amounts earned on the specific securities nor to the taxpayer's investment income but may be deducted in computing income from all sources. It should be noted, however, the deductibility of interest is subject to the provisions of section 67 of the Income Tax Act.

3. Otherwise deductible interest that is paid to a lender with funds that represent additional borrowings from the lender will remain deductible to a cash basis taxpayer.

4, Reasonable interest paid pursuant to a legal obligation on amounts borrowed to pay an interest expense that is deductible, is itself deductible.

The foregoing views represent the Department's current position on the deduction of interest expenditures in computing income for a taxation year.

Yours truly. . . .

[Emphasis added.]

The letter of October 5,1981 from Me Verchère to Mr. Frizzell, president of Justinian (Exhibit A-42), reads as follows:

[Translation.]

Dear Mr. Frizzell:

RE: Justinian Corporation S.A., Darius Corporation S.A., Spartacus Corporation S.A., Augustus Corporation S.A., Canadian income tax review

I refer to the ongoing review by Revenue Canada of the tax status of Justinian et al and the efforts I have made over the past few weeks to bring the matter to a

head. I met on Tuesday of last week with Mr. John Rowe, Chief, Section A, Tax Avoidance Section of Revenue Canada and reviewed with him in some considerable detail all of the facts surrounding the formation and operation of Justinian et al and the application of the Income Tax Act of Canada to those facts. There are, in the mind of Revenue Canada, three possible issues:

1. Are Justinian et al. subject to a Canadian income tax liability on the basis that they are managed and controlled from Canada or are a mere sham or conduit?

2. Is the interest on money borrowed by Canadian taxpayers to acquire stock in Justinian et al deductible in computing income for Canadian tax purposes?

3. On redemption of stock by Justinian et al., are the net proceeds a capital gain?

Mr. Rowe informed me on Tuesday that Revenue Canada's position was that Justinian et al are not subject to Canadian income tax liability, the interest on money borrowed to purchase stock in Justinian et al. is deductible and on redemption the net proceeds are a capital gain.

His conclusions are subject to the possible exception of persons whose purchase of stock and subsequent redemption took place in a very short period of time, say, less than a year. In this case, the transaction may be regarded as being in the nature of a trading transaction rather than an investment with the result that the gain on redemption would be income and not a capital gain. This, in my view, is a de minimis problem and need not concern you. Therefore, the Canadian income tax status remains as expressed in our opinion contained in the explanatory memorandum. As far as the interest deductibility issue is concerned, this is a question for each stockholder but, as a general rule, Revenue Canada's position is that they do not intend to seek to disallow interest deducted with respect to money borrowed to purchase stock in Justinian

It is clear from my meeting with Mr. Rowe that Revenue Canada has three areas of concern:

1. The capital gains treatment on redemption seems to provide an unintended benefit and I believe Revenue Canada will recommend to the Department of Finance that legislation be enacted to have the effect that upon redemption the portion of the proceeds which represents distribution of retained earnings will be treated as income to the stockholders and not a capital gain.

2. Revenue Canada fail to understand the true nature of the business carried on by Justinian et al and see the business as being very conservative and nothing much more than the purchase of bonds and other debt instruments which are then held until maturity.

3. Revenue Canada believe that the business of Justinian et al. is conducted from Nassau but, as they do not understand the business, they see the work done in Nassau as being merely clerical in nature and therefore the question of residence for income tax purposes is not as clear as it should be.

I explained to Mr. Rowe that the management of Justinian et al would probably not object to the type of legislation referred to above in item 1 but that management would hope that such legislation would not have a retrospective effect.

As far as points numbered 2 and 3 are concerned, I went to some considerable lengths to explain to Mr. Rowe the true nature of the business and the extent and sophistication of the management activities. I believe I persuaded them to some degree. However, I think it would be most useful if Mr. Rowe would go to Nassau and meet with you and the others for at least a full day so as to understand fully the true nature of the business being carried on in Nassau. I discussed this idea with Mr. Rowe and he agreed to consider travelling to Nassau for such a purpose and said that he would contact me in due course.

Yours sincerely,

(S) Bruce Verchère

[Emphasis added.]

The reference made by Me Verchère to Mr. Rowe (an employee of the Tax Avoidance section) as a basis of information is of considerable importance. Before this Court, however, during Mr. Rowe's examination in chief by counsel for the appellants, no question was asked concerning Me Verchère's assertions in Exhibit A-42.

Me Verchère, who was present at the hearing as a result of a subpoena sent by Me Du Pont, was not invited either to relate before Mr. Rowe the content of their conversation in October 1981. Furthermore, Mr. David Burton, who had met Me Verchère in Ottawa in October 1981, was categorical [in examination by Me Du Pont on May 6, 1991, page 68]:

[Translation.]

So, I definitely conveyed no message to Mr. Verchere and nobody conveyed such a message to him in my presence and I think my memory is quite clear on that.

9.04.4 The general balance of evidence on this point is that the appellants could not have been misled by the respondent's officers.

Mr. Irving Ludmer, who was at the decision-making level for the appellants, could not take into account the request for opinion submitted for the Steinberg employees concerning Spartacus on February 23, 1978 (Exhibit A-37) since it was subsequently withdrawn (Exhibit A-39).

With regard to Me Verchère's opinion in October 1981 (Exhibit A-42), that document did not emanate from Revenue Canada.

If Mr. Ludmer was influenced by this document in order to invest, he cannot reproach the respondent for it.

The senior authorities of Revenue Canada clearly ruled against deductibility of the interest. What the appellants criticized, however, was that they were reassessed retroactively starting in 1981.

9.05 Estoppel The appellants submitted that, by virtue of the principle of estoppel, the respondent could not legally issue reassessments (Nos. 354 to 360 of the argument outline, cited above at paragraph 8.05).

The appellants gave the essential points of their argument at No. 359. Let us review each of those items.

9.05.1 Audit of appellants

The only audit conducted in 1979 concerned Ludco's 1978 taxation year. Mr. Hirsh, the auditor, did not audit, as such, the deduction of interest with respect to investments in the "offshore" funds. On the contrary, he referred the whole to Mr. Herb Gutenplan of the Tax Avoidance section (Exhibit R-48).

As to the investigation conducted by Mr. Gutenplan in 1980 and 1981, its purpose was mainly to obtain information on the mode of operation of the foreign funds and the financing methods which the investors had adopted. The demand does not mention that the appellant Ludco had been the subject of a personal [sic] audit of its affairs for assessment purposes. Furthermore, we must recall that Mr. Gutenplan's investigation was not a regular audit of the company's affairs and its immediate purpose was not to assess the appellant Ludco, much less the Ludmer children, since, at the demand stage, no one knew of their investments in the foreign funds (examination of Mr. Herb Gutenplan, transcript of May 7, 1991, page 34).

Mr. Gutenplan examined Mr. Hirsh's letter concerning investments in "offshore" funds. However, Mr. Gutenplan had never examined the return of income of the appellant Ludco, or those of the children, much less the T20 audit report (Exhibit A-201), which shows once again that the primary purpose of the investigation conducted by Mr. Gutenplan was not to make an assess- ment of the appellant Ludco for its 1978 taxation year, that is the year audited by Mr. Hirsh, but rather in the context of a general investigation of the activity of foreign funds and of investments by Canadian taxpayers (examination of Mr. Herb Gutenplan, transcript of May 6, 1991, pages 141-42).

With regard to the Ludmer children, according to the respondent, no audit was conducted during the period 1977 and 1981. However, it appears from the report of Mr. Robert Hirsh (Exhibit A-201 at page 2478) that he noted that Mr. Irving Ludmer's three minor children had substantial income in the order of $180,000 “as per documents examined". There was apparently at least an examination of the financial statements, if not a thorough audit.

9.05.2 Representation through Information Circular 75-7R3

The appellants claimed that the respondent represented to the taxpayers that no reassessment would be issued where he should have observed an understatement of their taxes; the appellants referred to Information Circular 75-7R3 (Exhibit A-187) to support their claim.

On the one hand, the respondent never made any oral representation to the effect that no reassessment would be issued for the taxation years 1981 to 1985.

On the other hand, as regards this Information Circular 75-7R3, the Court is of the view that it is not applicable in the instant case.

The relevant passages of the Circular read as follows:

Reassessment of a return of income within the four-year limit

3. All pertinent aspects are studied to determine whether a return is to be reassessed within the four-year limit. The Department will normally

(c) not reassess where the understatement of tax in the return for the year should have been apparent to the Department, considering the degree of examination and audit that the return received

The Information Circular provides an overview of situations in which the Minister of National Revenue will consider issuing a reassessment. One cannot claim, however, that the Circular lends an imperative character to the manner in which the Minister of National Revenue must issue a reassessment. It must not be forgotten that it is subsection 152(4) which expressly provides that the respondent may, at a given time within the prescribed time limit, issue an assessment to a taxpayer. An information circular, having no legislative nature, may not submerge the object of the Act.

Subparagraph (c) of Information Circular 75-7R3 concerns the case in which there has been an audit of an income tax return for a taxation year.

In the instant case, in which the years 1981 to 1985 are in issue, this Circular cannot apply. Even if a thorough audit had been conducted for Ludco in 1979 for 1978, the respondent would not be prevented under this Circular from issuing an assessment for the years 1981 to 1985. The Minister is not bound with respect to the subsequent years. The same is true for the Ludmer children.

Lastly whether or not the Circular is applicable, the respondent is not bound by the Circular, but by the Act.

9.05.3 Appellants’ actions

The appellants claim that the fact that they had continued to claim a deduction for interest after the respondent's audits meant that they had acted to their prejudice since the respondent subsequently disallowed the interest deduction.

The appellants’ conduct can only be binding on themselves, particularly since the general audit of Ludco in 1979 could not be binding on the respondent for the years in issue.

Furthermore, the notion of estoppel constitutes a rule of evidence, but first the evidence must exist.

Lastly, estoppel cannot be used to go beyond the provisions of the Act. Furthermore, subsection 152(7) of the Act is clear on this subject:

(7) Idem. The Minister is not bound by a return or information supplied by or on behalf of a taxpayer and, in making an assessment, may, notwithstanding a return or information so supplied or if no return has been filed, assess the tax payable under this Part.

9.06 "Retroactive" assessments

9.06.1 The appellants contended that, since the interest deduction was granted in 1977 to 1980, and because the appellants did not subsequently change their behaviour, that is they still continued to deduct interest, the respondent should not have assessed them starting in 1981, but rather starting in 1985 and 1986, after advising them that the deduction of interest would henceforth be disallowed.

In short, the appellants alleged that a fair application of the Income Tax Act should mean that the Minister of National Revenue could not, five years after the fact and in a purportedly "retroactive" manner, dispute the validity of expenses which he had already allowed.

If this application appears fair in the appellants' eyes, it is, however, contrary to the very spirit of the Act. Subsection 152(4) expressly provides that the respondent may issue reassessments at any time. With this in view, a reassessment issued under subsection 152(4) is always" retroactive” to the extent that it reverses or amends a previously issued assessment.

The retroactive” effect which the issue of a reassessment causes cannot in any way affect the validity of that reassessment since Parliament has expressly provided the power to assess at any time within a prescribed time limit.

Furthermore, considering Exhibit A-39 (cited above at paragraph 9.04.3), dated May 3, 1978, which confirms certain fundamental principles pertaining to the deduction of interest expenses, it is clearly provided at paragraph 1 that the borrowed funds for which the interest was paid must have been used to earn income. However, in the first part of this judgment, the Court reached the contrary conclusion with regard to the money borrowed by the appellants in order to purchase the shares of Justinian and Augustus.

The letter of June 6, 1985 from the Honourable Perrin Beatty (Exhibit A-47) and those of January 17,1986 (Exhibit A-51) and March 11, 1986 (Exhibit A-52) from Mr. Harry Rogers disallowing the interest deduction merely confirm this fundamental position of the respondent.

9.06.2 Furthermore, the appellants claimed that the courts have on a number of occasions found that the government may not give retroactive effect to a change in interpretation of the Act or in administrative practice and, on that point, cited Québec (Sous-ministre du Revenu) v. Ciba-Geigy Canada Ltd., Québec (Sous-ministre du Revenu) c. Transport Lessard (1976) Ltée and Granger v. Canada Employmentand Immigration Commission, all supra, in support of their claim (Nos. 361 to 364 of the appellants’ argument outline, cited at paragraph 8.06.1).

9.06.2(1) In Ciba-Geigy, supra, the Quebec Court of Appeal found that the agreement reached between Revenu Québec and the company complied with the Retail Sales Tax Act. Consequently, there is nothing that enabled the Minister to decide otherwise [at page 158]:

Our case is quite different from that in which a minister might have enacted regulations contrary to the Act.

9.06.2(2) The appellants also relied on Lessard, supra, which itself relied on Ciba-Geigy. The Court of Appeal here again affirmed that the administrative practice had for many years been applied, to the Act in a thoughtful and not unreasonable manner" [translation].

9.06.2(3) In Granger, supra, Pratte, J.A. wrote the following concerning Lessard [at page 77 (D.L.R. 505)]:

[Translation.]

A judge is bound by the law. He cannot refuse to apply it, even on grounds of equity. Of course, this fundamental truth is difficult to reconcile with the judgment of the Quebec Court of Appeal in Transport Lessard and the observations of the House of Lords in Ex parte Preston, [1985] A.C. 835. That is why I am inclined to think that those two judgments are not beyond criticism.

In his answer (No. 177), counsel for the appellants emphasized that "the difficulties in reconciling the opinions of Pratte, J.A. in Granger, of Hugessen, J.A. in Bendahmane and of the Lords in Preston do not arise here since all the judgments concord on the point that the respondent's representations on questions of fact will be binding on him. However, the question of whether a loan was used for the purpose of gaining or producing income is a question of fact.”

It is a question of fact which is contingent on a question of law, that is subsection 9(3) of the Act concerning which I have given my decision (7.01).

9.06.2(4) The balance of evidence in the instant case does not show any previous agreement between the appellants and the respondent on the subject of the deduction of interest.

Furthermore, the evidence clearly shows that Mr. Ludmer had been influenced rather by the letter of Me Verchère (Exhibit A-42), which did not emanate from the respondent, and by the letter of 1978 (Exhibit A-39), which concerns only the application of paragraph 20(1)(c).

In my view, the Act does not allow the deduction of interest, and, according to the case law cited above, it is the Act which takes precedence.

9.07 During the investigation in the form of interlocutory objections [sic], the appellants objected to a certain number of exhibits filed by the respondent:

Exhibit R-49, tabs 1 to 19;

Exhibit R-50, tabs 1 to 29;

Exhibit R-51, tabs 1 to 36.

The appellants claimed that these documents could be admitted only for identification purposes, that is to establish that they had been considered by the respondent's officers and not in order to prove their content.

The appellants further claimed that the respondent had not proved the content of those documents and that the testimony of the respondent's officers, in particular that of Mr. Gutenplan concerning the content of Exhibit R-50, tab 23, constituted inadmissible hearsay.

Of the 84 documents (19, 29 and 36) to which the appellants objected, 58 originated from Mr. Arnold Steinberg, 16 from the Mercantile Bank and one from the firm Verchère, Gauthier, the appellants’ former legal advisor.

All these documents were obtained during the respondent's investigation, and many of them form the basis of the facts assumed by the respondent. However, those facts, according to an undisputed doctrine, are presumed to be true.

We should remember the remarks of Rand, J. in Johnston v. M.N.R., [1948] S.C.R. 486, [1948] C.T.C. 195, 3 D.T.C. 1182, where he explained, with regard to the reply to the notice of appeal [at page 489, C.T.C. 202, D.T.C. 1183]:

[Translation.]

Every such fact found or assumed by the assessor or the Minister must then be accepted as it was dealt with by these persons unless questioned by the appellant.

Furthermore, 30 of those 84 documents were also filed by the appellants, and 18 were transmitted by Mr. Irving Ludmer.

With regard to Exhibit R-50, tab 23, on the subject of which in particular the appellants argued that it constituted hearsay, it formed the basis of the fact assumed at subparagraph t" of the amended reply to Ludco's notice of appeal. The facts described are therefore also presumed to be true.

If the exhibits originating from the investigation could not be filed, the auditor could not have been in a position to explain the facts on which he relied in order to make his assessment.

The objections are dismissed.

10. Conclusion from paragraphs 8 and 9

The Court therefore finds that it must dismiss the appellants’ claim, that is that the reassessments are arbitrary, discriminatory, unfair, contrary to estoppel and pursuant to a retroactively amended established policy.

11. General conclusion

The appellants’ appeals are dismissed.

Appeals dismissed.