Harvey Kalef v. Minister of National Revenue, [1992] 1 CTC 2771, 92 DTC 1450

Rip, T.C.C.J.:—The appellant, Harvey Kalef ("Kalef"), in computing his income for each of 1983 and 1984, deducted amounts of interest paid on funds purportedly borrowed for the purpose of gaining or producing income from property: 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 1983 Kalef deducted $10,505.43 and for 1984, $60,833. In reassessing, the Minister of National Revenue, the respondent ("Minister"), disallowed the deductions and the appellant has appealed the reassessments. [1]

The pleadings did not facilitate the determination of the issues. Neither the appellant's notice of appeal prepared by a national accounting firm nor the respondent's reply to the notice of appeal set forth or alleged facts upon which either party relied on to support its position. [2] The respondent stated in his reply that, with respect to the deductibility of interest, he relied, inter alia, upon the following findings or assumptions of fact:

a) the facts hereinbefore admitted;

h) the appellant did not use the borrowed funds to gain or provide income from a business or to acquire property for the purpose of gaining or producing income;

and

i) the interest expense incurred by the appellant was a personal or living expense.

The only facts "hereinbefore admitted" by the respondent were that an appeal is being fled, the date of the notice of confirmation of the assessments for 1983 and 1984 and the respondent disallowed the expenses claimed by the appellant. The respondent's findings or assumptions described in paragraphs (h)and (i) above are not findings or assumptions of facts but conclusions of law. In short, it appears the respondent did not plead any finding or assumption of fact. There was, therefore, no onus on the appellant to demolish any basic facts on which the assessments rested. However, since Kalef is the appellant he has the burden of proof of a plaintiff to prove his case. [See Johnston (R.W.S.) v. M.N.R., [1948] S.C.R. 486, [1948] C.T.C. 195, 3 D.T.C. 1183.]

In his opening statement the appellant's counsel explained that the amounts of interest claimed as deductions by his client were in respect of three loans outstanding in each year. In 1983, Kalef says, he paid interest to the Bank of Nova Scotia, and to Ottawa and Toronto branches of the Continental Bank of Canada. In 1984, he says, he paid interest to Ottawa and Toronto branches of the Continental Bank and to one Hennick.

At the conclusion of trial I found there was no evidence that any interest paid to the Bank of Nova Scotia and the branch of the Continental Bank was for money borrowed by Kalef for the purpose of earning income from a business or property. Kalef was not certain of the purpose of any of the loans or the use to which he put the borrowed funds. In short, Kalef could not trace the funds borrowed from the Toronto branch of the Continental Bank to a specific eligible use which could trigger the deduction and therefore is not permitted to deduct the interest paid on such loans: The Queen v. Bronfman Trust, (1987) 1 S.C.R. 32, [1987] 1 C.T.C. 117, 87 D.T.C. 5059 at 129 (D.T.C. 5067).

I stated I would consider in these written reasons only whether the amounts of interest paid on the loans from the Ottawa branch of the Continental Bank and from Hennick were deductible in computing income for 1983 and 1984.

Continental Bank loan

In 1983, Imaginamics Inc. ("Imaginamics") was a corporation incorporated in Ontario whose shares were traded "over the counter” in New York. The company was not a" reporting issuer”, as that term is defined in the Securities Act of Ontario, in January 1984 or earlier. One of its shareholders was Bytec Management Corporation Inc. ("Bytec"). Imaginamics, in tum, owned all of the issued and outstanding shares of the Bynamics Corporation (” Bynamics").

Kalef testified that during the summer of 1983, the president of Bynamics and former Chief Financial Officer of Bytec, Mr. William Baker ("Baker"), negotiated the purchase from Bytec of its 3,272,542 shares of Imaginamics for $800,000. Each of Kalef and Baker agreed to aquire 1,636,271 shares of Imaginamics through Baker, in Trust.

Baker resided in Ottawa where Imaginamics had its office and, according to Kalef, arranged with the Ottawa branch of the Continental Bank for each of them to obtain a loan, in Kalef's case for $350,000, to purchase the Imaginamics shares.

In a Continental Bank form entitled "Personal Statement of Affairs", as at July 15, 1983, Kalef reported amongst his assets 2,037,000 shares of Imag- inamics. Kalef stated this form was“ probably” prepared to obtain the $350,000 loan. By letter dated July 26, 1983, the Continental Bank approved a $350,000 Demand loan” by way of line of credit for the purpose of purchasing shares of Imaginamics from Bytec. The advances were to be repaid from sale proceeds of Imaginamics shares by April 30, 1984 as follows: 116,000 by October 31, 1983, $117,000 by January 31, 1984 and $117,000 by April 30, 1984. The interest rate on the $350,000 was the bank's prime rate plus 2% calculated and payable monthly. The shares of Imaginamics being acquired were to be hypothecated or assigned to the bank sufficient to maintain a market value to loan ratio of 4:1 at all times.

The bank transferred $350,000 to Kalef's account on August 9, 1983. Kalef then issued two cheques to Bynamics, one on August 10 in the amount of $100,000 and the other on August 12 in the amount of $250,000. In reply to my question why he wrote cheques to Bynamics, Kalef said "the company needed money" and so advanced the funds to Bynamics until the purchase of Imaginamics shares would take place. He could not explain the reason for writing two cheques.

Kalef testified it took until January 1984 to purchase the Imaginamics shares. He said $10,000 was paid for the shares in August 1983 and $640,000 was paid at the end of January, 1984. He added "we were unable to come up with the balance of the money and it was subsequently forgiven". However, before the "forgiveness" took place, the vendor sued Baker and Kalef. The action was subsequently abandoned.

The agreement between Baker, in Trust and Bytec for the purchase and sale of the Imaginamics shares was made as of the 26th day of January 1984. According to the agreement the purchase price was to be paid as to $10,000 on closing, that is, January 31, 1984, $640,000 to be paid on February 29, 1984 and $150,000 to be paid on August 31, 1984. The balance of the purchase price was secured by the grant by Baker, in Trust to Bytec of a pledge of 660,000 shares of Imaginamics being purchased. Kalef said he received his portion of the Imaginamics shares, which I assume to be 1,306,270 shares.

At one stage in his examination in chief Kalef stated that Bynamics [3] wrote a cheque in the amount of $350,000 to Bytec for his share of the purchase price, effectively repaying the $350,000 it borrowed from Kalef. Elsewhere in his examination he appeared to imply that the money went from Bynamics to Baker "to permit us to close”. He confirmed the latter sequence in replying to questions I put to him. Later on, in cross examination, he recalled he originally thought he "got the money from Continental Bank" and gave it to Baker, in Trust to pay Bytec. But, he said, he remembered he had recently reviewed documents and discussed the events with Baker. Baker reminded him “I loaned the money to Bynamics and when the deal closed Bynamics repaid the loan by paying for the shares". Kalef also stated Bynamics was to have paid interest on the loan but could not say if he received any interest; he did not report the receipt of any interest from Bynamics in his 1983 or 1984 tax returns.

Kalef stated he acquired the shares of Imaginamics to earn income in the form of dividends. On acquisition of the shares, he and Baker controlled Imaginamics.

The Continental Bank confirmed the amounts of interest Kalef claimed to have paid on the $350,000 loan during the years of appeal. By letter of November 13, 1985 the bank advised him that in 1983, for the period August 9 to December 31, he paid $6,799.64 in interest. On May 22, 1985 he had been informed interest paid by him to the bank in 1984 was $35,408.93.

Lloyds Bank, the successor to the Continental Bank, wrote Kalef on February 8, 1990 that"[o]ur credit application dated August of 1983, shows that the purpose of the loan of $350,000 was to purchase 245,158 shares of the Bynamics Corporation from Bytec Management. Shares to be converted to 1,158,865 shares of Imaginamics Inc. . . .”. On September 13, 1991 the Hongkong Bank of Canada, the successor to Lloyds Bank, wrote to Kalef's solicitor to confirm, among other things, $17,808 was still outstanding on the loan and that "the loan was used to purchase 245,158 shares of . . . Bynamics . . . from Bytec. .. . . These shares were converted 1,158,865 shares of Imaginamics. . . .”.

Kalef explained that when things were not going well with the amalgamated corporation he negotiated with the Continental Bank to repay the balance of the loan of $117,000 over five years without interest.

In cross examination Kalef acknowledged he sold 104,000 shares of Imaginamics in 1983; in the summary of dispositions of capital property in his 1983 income tax return, he reports he acquired the Imaginamics shares in 1983. In his 1984 tax return, he reports the sale in the year of an unknown number of Imaginamics shares he acquired in “multi” years. He could not say at trial whether or not he acquired shares of Imaginamics in 1983, but could recall he first acquired the Imaginamics shares in 1977.

By an apparent agreement dated May 3, 1983 Kalef agreed to transfer 250,000 shares of Bynamics he owned to Imaginamics in consideration of 1,181,750 shares of Imaginamics. [4] At the same time Bytec agreed to transfer 692,308 shares of Bynamics to Imaginamics in consideration of 3,272,540 shares of Imaginamics and Baker, in Trust agreed to transfer 297,692 shares of Bynamics to Imaginamics for 1,407,190 shares. Imaginamics issued its shares from treasury to Kalef as well as Bytec, Baker, in Trust and Kanata Genesis Fund on July 29, 1983.

Kalef stated that as a result of the bankruptcy of Bynamics Corporation in May 1985 he lost control of documentation relevant to the matters in appeal and had difficulty establishing certain facts.

Hen n ick loan

Kalef testified that since 1975 he, Irving Hennick and Gilbert Blechman were partners in a partnership known as"KHB Partnership”. The partnership built The National Golf Club near Woodbridge, Ontario. The partnership agreement provided, Kalef declared, that if any partner was unable to contribute to the partnership's capital account, that partner would lose his interest in the partnership.

Kalef said he "ran into trouble . . . and could not make payments" to the partnership. He borrowed money from Hennick to contribute to the partnership so as not to lose his interest. When the partnership sold off a piece of land in 1981 it took a mortgage back, payable in 1984. Out of Kalef's proceeds from the mortgage in 1984, Hennick was repaid the amount of the loan plus interest of $22,000, Kalef insisted.

A copy of an agreement dated July 27, 1981 between Hennick, Blechman, a corporation and Kalef was produced by Kalef to corroborate his testimony. The recitals refer to the KHB Partnership, a partnership agreement dated June 1, 1975 as well as other related agreements and a mortgage, dated June 15, 1981, the partnership owned in the amount of $993,605. In the agreement Kalef acknowledges his indebtedness to Hennick in the amount of $131,000. The sum was to be payable in full on the earlier of June 22, 1985 or payment in full of the mortgage. The indebtedness bore interest at 13 per cent per annum, calculated monthly. The agreement also provides for the directors by Kalef to the partnership to pay Hennick from his share of the receipts of the mortgage the principal of the indebtedness and interest.

Respondent's counsel did not cross examine Kalef on this matter.

Argument

In the Minister's view, the respondent's counsel submitted, Kalef borrowed the $350,000 to purchase the Bynamic shares which were subsequently "converted" into Imaginamics shares in July 1983 and, as reported in his returns for his 1983 and 1984, he subsequently sold Imaginamics shares. Counsel referred to Kalef initial testimony in cross examination: firstly, Kalef testified he did not acquire any Imaginamics shares in 1983 and only when he was shown the copy of the certified copy of resolution of the directors of Imaginamics, dated July 29, 1983, authorizing the issuance of shares in consideration of Bynamics shares did Kalef acknowledge his acquisition of Imaginamics shares in 1983, she stated. Counsel added that Kalef could not say with any certainty when he acquired the Imaginamics shares he sold in 1983 and 1984.

Counsel for the Minister also argued that the Continental Bank, in its letter of July 26, 1983, authorized a credit line of $350,000 to Kalef. Since the transaction for the Imaginamics shares would not close until January 1984 she wondered why Kalef drew on his line of credit in August for the purpose of advancing funds to Bynamics.

In counsel's view, the resolution of Imaginamics of July 29,1983 "ties in with the letters" from the Lloyds Bank and Hongkong Bank, that is, that the borrowed funds were used to acquire 250,000 shares of Bynamics and had nothing to do with the acquisition of Imaginamics shares. She also queried the relatively low amount of interest paid by Kalef on the loan for the six month period in 1983, to wit, $6,799.64, compared to interest paid in 1984, $35,408.93, when the principal sum was supposedly being reduced in accordance with the loan agreement.

With respect to the Hennick debt, counsel for the Minister did not dispute Kalef was indebted to Hennick, but argued that there was no evidence the indebtedness was incurred to earn income from a business or property.

The Minister's counsel submitted that the appeals ought to be dismissed since Kalef could not trace the use of the borrowed funds. She relied on the reasons of the Chief Justice in The Queen v. Bronfman Trust, op. cit., at page 124 (D.T.C. 5064), where he stated:

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. Therefore, if the taxpayer commingles funds to an identifiable use which triggers the deduction: see, for example, Mills v. M.N.R., [1985] 2 C.T.C. 2334, 85 D.T.C. 632 (T.C.C.), No. 616 v. M.N.R., Tax A.B.C. 22, 59 D.T.C. 247 (T.A.B.).

. . .Consequently, the focus of the inquiry must be centred on the use to which the taxpayer put the borrowed funds.

Counsel also was of the view that if the borrowed funds were used to acquire Imaginamics shares, these shares were no longer owned by Kalef due

to their sales in 1983 and 1984; the source of income no longer existed: Emerson v. The Queen, [1986] C.T.C. 422, 86 D.T.C. 6184 (F.C.A.).

Kalef's counsel submitted, very simply, that Kalef borrowed the $350,000 from the Continental Bank for the purpose of acquiring Imaginamics shares from Bytec. Until closing of the transaction, Kalef arranged for Bynamics to use the funds and in consideration of receiving interest. However, due to the records being lost during the course of bankruptcy of the amalgamated corporation, Kalef was unable to corroborate his testimony that Bynamics was liable to pay interest to him.

Kalef testified, his counsel declared, he owned shares of Imaginamics since the company was incorporated in 1977. His personal statement of affairs on the Continental Bank form states he owned 2,037,000 shares of Imaginamics as at July 15,1983. Counsel also referred me to subsection 71 (4) of the Securities Act of Ontario which, in the circumstances of the transaction between Bytec to Baker, in Trust, prevents the purchaser from disposing in 1984 of the shares he acquired in that year. Thus, counsel concluded, Kalef could not have sold any of the Imaginamics shares he acquired from Bytec with the funds borrowed from the Continental Bank. This potential source of income, the Imaginamics shares, continued to exist in 1984.

In respect of the Hennick loan, counsel for Kalef submitted that his client was not cross examined on his testimony and therefore his evidence that he borrowed money from Hennick to permit him to contribute capital to the partnership should be believed.

Conclusion

The evidence is clear that Kalef borrowed $350,000 from the Continental Bank on August 9, 1983 and advanced this amount to Bynamics on August 10th and 11th, 1983. Since he received the money from the bank on August 9, 1983 I cannot understand what appears to be one of the Minister's arguments, that Kalef used the borrowed funds to acquire shares of Bynamics which he subsequently transferred to Imaginamics for shares of Imaginamics. True, this is the scenario described in the letters from Lloyds Bank and Hongkong Bank but the evidence before me is that Kalef transferred the Bynamics shares to Imaginamics on July 29, 1983 pursuant to share purchase agreement dated May 4, 1983. It is quite obvious that since Kalef received the funds from the bank on August 9 he could not have applied these funds to the acquisition of Bynamics shares which had taken place at the latest, prior to May 4,1983. (Counsel for the respondent did not suggest Kalef did not own the Bynamics shares he agreed to sell at the time he signed the agreement of May 4, 1983.)

Another position taken by the Minister was that in 1984 Kalef sold the Imaginamics shares he acquired from Bytec. Kalef declared to the Continental Bank that as of July 15,1983 he owned 2,037,000 shares of Imaginamics. He was not cross examined whether the 2,037,000 shares may have included the 1,181,750 shares he was to receive from Imaginamics pursuant to the May 4, 1983 agreement. I assume it did not. It would appear, therefore, Kalef had sufficient shares of Imaginamics in 1983 to sell 104,000 in that year and subsequent shares in 1984 without resorting to selling any of the shares he acquired from Bytec in 1984. Surely, he could not have sold in 1983, shares he purchased in 1984. I do not find anything sinister in Kalef's initial reply during cross examination that he did not acquire any Imaginamics shares in 1983. The shares he acquired from Bytec in 1984 continued to be owned by him during 1984 and the shares he received in the amalgamation was substituted” priority. [5] (I need not, therefore, consider whether Kalef would have contravened the provisions of the Securities Act of Ontario by selling these shares, to the extent this may have been relevant.)

I do have some doubt as to the arrangement between Kalef and Bynamics with respect to the payment of interest of the $350,000 advanced to that corporation. I appreciate that after a bankruptcy documents may be lost and are not available when required as proof years later before a Court of law. When Kalef first described the loan from the Continental Bank and his "putting the money into" Bynamics he omitted any reference to interest. It was only later when he was asked if interest was payable by Bynamics did he state it was. However, I could not determine if Bynamics was legally obliged to pay interest on the loan or whether Kalef was under the impression interest would be paid. Kalef, as creditor, ought to have had some proof of the interest payable; in the circumstances of this case financial statements of Bynamics prior to amalgamation reflecting the loan and its terms would have sufficed. In fact, Kalef received no interest from Bynamics either in 1983, or in 1984 when the loan was repaid. I must conclude that on the balance of probability, Kalef advanced the $350,000 without interest.

Since the shares of Imaginamics, for which the money was borrowed to purchase, were not purchased until 1984, the funds were not borrowed by Kalef in August 1983 for the purpose of earning income in 1983. None of the $6,799.64 paid as interest to the bank in 1983 is deductible in computing income for 1983.

As far as 1984 is concerned, the $350,000 was applied in 1984 to acquire shares of Imaginamics and the shares, or property substituted therefore, were continued to be owned by Kalef during that year. The amount of interest of $35,408.93 paid by Kalef to the Continental Bank during 1984 is deductible in computing income for 1984.

With respect to the Hennick loan, I have no reason to disbelieve Kalef's evidence that he borrowed $131,000 from Hennick for the purpose of contributing to the capital of a partnership that carried on a business. His evidence on this matter was not inconsistent with other evidence.

The appeal for 1983 will be dismissed. The appeal for 1984 will be allowed and referred back to the respondent for reconsideration and reassessment on the basis Kalef be permitted to deduct only the amounts of interest paid in 1984 to the Ottawa branch of the Continental Bank and Hennick. Kalef will be allowed costs for his 1984 appeal.

Appeal allowed in part.