Walter F. Botkin v. Minister of National Revenue, [1989] 2 CTC 2110, 89 DTC 398

Brulé, T.C.J.: —The appellant appeals from a reassessment of income tax for his 1985 taxation year. There are two issues involved. One is a business loan deduction claimed by the appellant and disallowed by the Minister, and the other is a claim as a deduction from income of interest paid to a bank.

Facts

Prior to April 1984, the appellant and an associate owned a successful tire retreading business. Effective March 31, 1984, the business was sold to the appellant's children at which time he loaned the company $260,000. This loan had no terms of repayment except that no repayments were anticipated prior to 1990. It was also interest-free. The appellant, who was not a shareholder of the company, entered into an agreement appointing him the general manager of the company and was by this entitled to an annual salary and a bonus equal to ten per cent of the net income of the company in each financial year.

Conditions in the market changed drastically and the company failed with the result that the appellant claimed the sum of $130,000 as an allowable capital loss in his 1985 income tax return, but was disallowed.

In addition to the above (and the second issue under appeal) the appellant had been a partner in a restaurant operation. To assist in its operation a bank provided a line of credit. In 1982 the business was sold to a restaurant company under an agreement for sale which provided for a down payment, and monthly payments until 1987, with interest at 15 per cent. The agreement provided that any amounts outstanding could be prepaid. On January 8, 1985 the purchaser of the business paid up the then outstanding balance. The moneys paid went to the bank but there was in excess of these an outstanding balance of $5,038 which was paid by the appellant as interest to the bank in 1985. He sought to deduct this amount from income during that year. This was disallowed by the Minister.

Appellant's Position

Counsel for the appellant claimed with respect to the loss of $260,000 that the appellant was entitled to an allowable capital loss of $130,000 on the ground that he had a reasonable expectation of profit from the operation of the tire retreading business. Consideration for the loan had been given in the form of a ten per cent bonus of net income and it was suggested that this was superior to an interest factor which might have been attached to the note representing the loan.

In support of this argument the Court was directed to the provisions of paragraph (g) of subsection 40(2) of the Income Tax Act which allows for a loss if the debt was acquired for the purpose of gaining or producing income. Reference was made to the cases of M. Sirois v. M.N.R., [1988] 1 C.T.C. 2147; 88 D.T.C. 1114 and Moldowan v. The Queen, [1978] 1 S.C.R. 480; [1977] C.T.C. 310; 77 D.T.C. 5213.

With reference to the interest deduction claimed of $5,038 counsel relied on the wording of paragraph 20(1)(c) of the Income Tax Act which refers to “an amount paid in the year” and even though the purchasing restaurant paid off its outstanding balance in January of 1985, the appellant paid the sum in question in the 1985 year. It was suggested and conceded that even though interest was earned at 15 per cent per annum from January 1 to January 8, 1985 and no source was in existence subsequent to January 8, this was not material as the amount was paid in the 1985 taxation year. Reference was made to the case of FT. Howland v. M.N.R., [1987] 1 C.T.C. 2269; 87 D.T.C. 186 as an analogous situation.

Minister's Position

Counsel submitted that the appellant's claim to an allowable business investment loss in 1985 in the amount of $130,000 should be disallowed in that the debt was not acquired for the purpose of gaining or producing income from a business or property and, pursuant to paragraph 40(2)(g) of the Income Tax Act, the appellant’s loss is nil. The arrangement made with the corporation as to the loan being without interest is not offset by a possible ten per cent bonus of the corporation's net income.

With respect to the appellant's claim to deduct interest of $5,038 in 1985 pursuant to paragraph 20(1)(c) of the Income Tax Act the Court was told that the interest was not payable pursuant to a legal obligation to pay interest on borrowed money used for the purpose of gaining or producing income from a business or property that was in existence at the time that the appellant paid the interest. Counsel referred particularly to the cases of The Queen v. Phyllis Barbara Bronfman Trust, [1987] 1 S.C.R. 32; [1987] 1 C.T.C. 117; 87 D.T.C. 5059, Donald M. Lyons v. M.N.R., [1984] C.T.C. 2690; 84 D.T.C. 1633, and Russell I. Emerson v. The Queen, [1986] 1 C.T.C. 422; 86 D.T.C. 6184.

Analysis

While the appellant claimed he had a reasonable expectation of profit in his involvement with the tire retreading business and claimed a capital loss of $130,000 the structuring of his loan does not support this contention. In evidence it was stated that the loan details were conceived by the company's accountant who admitted this was so and said that the terms of the loan were set in the hope of gaining certain advantages. These could be summarized as follows:

(1) a long period to pay off the note was included,

(2) no interest was included resulting in less annual liability and therefore more acceptable by the bank who also had loaned funds, and

(3) the flexibility afforded by a bonus arrangement instead of a fixed rate of interest.

The accountant indicated he was sure that the loss would have been allowed if a rate of interest had been included with the loan which could have been accrued to the benefit of the appellant. This was an admission to the Court that what was done was not acceptable.

In business, one can never count on making a profit, especially as a basis for structuring a transaction. One must accept what was done and not what might have been done. In the case of Lakeview Gardens Corporation v. M.N.R., [1973] C.T.C. 586; 73 D.T.C. 5437. Walsh, J. in setting out the principle that it is not what the taxpayer might have done to minimize taxation that determines the issue but that the taxpayer must abide by the position taken. He quoted at page 5440 from the judgment of Lord Simon in Commissioners of Inland Revenue v. Wesleyan and General Assurance Society, [1948] 1 All E.R. 555; 30 T.C. 11 when he said at page 25:

In dealing with Income Tax questions it frequently happens that there are two methods at least of achieving a particular financial result. If one of those methods is adopted tax will be payable. If the other method is adopted tax will not be payable . . . The net result from the financial point of view is precisely the same in each case, but one method of achieving it attracts tax and the other method does not . . .

It is not what you do but the way that you -écrit which counts. In the present case the purpose of the loan as being a basis for “gaining or producing income” as set out in paragraph 40(2)(g) of the Income Tax Act was only an expectation, not a sound business arrangement capable of qualifying the loan, as required by the statute. If it had not been that the company was sold to the appellant’s children perhaps he would not have entered into this type of loan arrangement.

I cannot see how the cases quoted by the appellant's counsel assist in his argument. This issue in the appeal is dismissed.

The second issue involves the deductibility of the interest expense of $5,038 by the appellant under the provisions of paragraph 20(1)(c) of the Income Tax Act. In order to qualify for such a deduction the interest must be payable pursuant to a legal obligation to pay interest on borrowed money used for the purpose of gaining or producing income from a business or property and that was in existence at the time that the interest became due.

In the present case while the appellant was a partner in the restaurant interest was paid to the bank in relation to the line of credit the restaurant was given. After the restaurant was sold the new purchaser undertook to make payments to the bank. When the balance was paid on this purchase on January 8, 1985, there was still remaining the amount in question to be paid by the appellant. Can this properly be deducted by the appellant in his 1985 taxation year as he alleges?

To accept this contention it would be necessary to interpret paragraph 20(1)(c) of the Income Tax Act as meaning that a taxpayer is entitled to an interest expense deduction for interest accrued for the whole year on borrowed money as long as the source of income for which the money was borrowed is in existence for at least one day during the year. This could mean that if one borrowed $100,000 on January 1, to buy income producing property with interest at ten per cent, then sold that property on January 2, he would be entitled to claim an interest expense deduction of $10,000 at the end of the year.

I do not believe that this is a valid interpretation to give to this paragraph. Although Cattanach, J. said at page 578 (D.T.C. 5417) in Lyle A. Meredith v. The Queen, [1975] C.T.C. 570; 75 D.T.C. 5412, that "income tax is an annual affair" in trying to ascertain the meaning of a provision of the statute the Court must nevertheless adopt a "words-in-total-context approach"; as set out in Lor-Wes Contracting Ltd. v. The Queen, [1985] 2 C.T.C. 79; 85 D.T.C. 5310 at page 83 (D.T.C. 5313) (F.C.A.).

In the case of Russell I. Emerson v. The Queen, [1985] 1 C.T.C. 324; 85 D.T.C. 5236, affirmed by the Federal Court of Appeal, [1986] 1 C.T.C. 422; 86 D.T.C. 6184 and leave to appeal to the Supreme Court of Canada refused, the matter of interest deduction in similar circumstances is well discussed. In the Federal Court-Trial Division there is found at page 26 (D.T.C. 5237) the following:

Thus an interest expense is deductible under the Income Tax Act only as an expense of earning or producing income, and if the source of those earnings, be it business or property, no longer exists, the exemption disappears.

Further in the same page Cullen, J. says:

An essential requirement, therefore, of any deduction on account of interest pursuant to 20(1)(c) is the existence of the source to which the expense relates and if the source has been terminated, as is the case here, the interest expense is no longer deductible. The continuing obligation to meet the interest costs of an outstanding loan, after the source has been extinguished, is not relevant.

In the case of Scott McKay and Ronald Heale v. M.N.R., [1984] C.T.C. 2805; 84 D.T.C. 1699 the appellants borrowed money to purchase shares, sold these in June and took back a mortgage, then deducted interest for the year. The Court held that when the shares were sold the income from that source was cancelled and the interest could not be deducted from any other source of income, in that case the mortgage.

If the reasoning in the McKay case, supra, were to be adopted the end result would be that the taxpayer would not be entitled to any interest expense deduction in his 1985 taxation year because the original source of income, the restaurant business, was sold in 1982.

In the case of The Queen v. Phyllis Barbara Bronfman Trust, supra, the Supreme Court of Canada recognized 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. The present case involves the borrowed funds being originally used for an eligible income-earning purpose and then changed to another eligible use in the sale of the restaurant when the new purchaser was paying 15 per cent to the vendors until January 8, 1985. On this date the source disappeared and in view of the interpretation of paragraph 20(1)(c) as set out above the most the appellant can claim is a deductible interest expense for eight days in 1985, which would produce an amount of 8/365 X $5,038 = $110.42.

Judgment therefore is given on the basis that the appellant is allowed an amount of $110.42 for the year 1985, and in all other respects the appeal is dismissed without costs. The matter will be referred back to the Minister for reconsideration and reassessment on this basis.

Appeal allowed in part.