Patrick W. Riddell, Sparkle Car Wash Ltd. v. Minister of National Revenue, [1986] 1 CTC 2500, 86 DTC 1374

Goetz, T.C.J.:— These are appeals by the above-named appellants ("Sparkle” or “the Company” and "Riddell" or "the appellant") relating to reassessments for their 1977, 1978, 1979 and 1980 taxation years. The appellant Sparkle sought to deduct from income certain interest expenses relating to payments made by it on account of principal and interest on a loan taken from a bank by its sole shareholder Riddell. The appellant Riddell objects to the payments by Sparkle of principal and interest on account of his personal loan being included in his income by Revenue Canada.

The appeals were heard on common evidence. An agreed statement of facts was filed and reads as follows:

AGREED STATEMENT OF FACTS

The parties hereto, by their solicitors, hereby agree to the following facts for the purposes of the Appellants’ appeals of their 1977, 1978, 1979 and 1980 taxation years:

1. The Appellant Patrick W. Riddell (hereinafter ‘Riddell’) is a public servant residing in the City of Winnipeg, in the Province of Manitoba, who, at all material times, was a director, the President, and sole beneficial shareholder of the Appellant, Sparkle Car Wash Ltd. (hereinafter ‘Sparkle’).

2. The Appellant Sparkle is a corporation duly incorporated under the laws of the Province of Manitoba, with its registered office in the City of Winnipeg. Until the 1975 taxation years, (sic) Sparkle carried on business as a car wash.

3. In the 1973 taxation year Riddell purchased all the outstanding shares in Sparkle for the sum of $235,000.00. Of this amount, Riddell borrowed $139,750.00 from the Bank of Montreal which was guaranteed by Sparkle, $64,250.00 was also borrowed from the Bank of Montreal but guaranteed by Riddell’s wife and mother- in-law, and $20,000.00 by way of a mortgage against his house. The guarantee by Sparkle was secured by a real property mortgage on the land and building owned by Sparkle.

4. Sparkle made the required principal and interest payments to the Bank of Montreal on behalf of Riddell from 1973 through 1975. During this period, the payments made by Sparkle on behalf of Riddell were expensed by Sparkle as wages to Riddell and the other part of the payments were debited to Riddell’s shareholder loan account.

5. During the 1975 taxation year, Sparkle borrowed $103,000.00 from the Bank of Montreal for the purposes of carrying out renovations to its building.

6. During the 1975 taxation year Sparkle ceased carrying on business as a car wash, renovations were carried out on its premises which were thereafter leased to earn rental income. Riddell became employed with the federal government.

7. Renovations took place during 1975. A contribution to the cost of same was to be made by one of the tenants, as soon as renovations were completed. When this payment was not immediately forthcoming, the Bank required additional security.

8. As a result a demand debenture in the principal amount of $282,000.00 was given by Sparkle, and assignments of lease payments were taken. At the same time the Bank of Montreal consolidated the loans of Riddell and Sparkle into a single loan in the name of Sparkle. As at November 30, 1976 the balance of this loan was $276,752.55.

9. Commencing in the 1976 taxation year and continuing until March 1978, Sparkle made all required payments of principal and interest on the consolidated loan from the Bank of Montreal.

10. Sparkle deducted as business expense the full amount of the interest payments made to the Bank in respect of the consolidated loan. Sparkle’s financial statements for such period show that the principal portions of the payments were applied to reduce Sparkle’s share of the outstanding amount of the consolidated loan. In Sparkle’s financial records, no portion of the principal payments were applied to reduce Riddell’s share of the consolidated loan.

11. In March 1978 Sparkle and Riddell changed banks from the Bank of Montreal to the Canadian Imperial Bank of Commerce (hereinafter ‘C.I.B.C.').

12. Also in March 1978, that portion of the consolidated loan from the Bank of Montreal which was properly attributable to Riddell was paid out of a new loan from C.I.B.C. to Riddell in the amount of $216,000.00.

13. Also in March 1978, that portion of the consolidated loan from the Bank of Montreal which was properly attributable to Sparkle was paid out of a new loan from C.I.B.C. to Sparkle in the amount of $60,000.00.

14. As a condition of granting the aforesaid loans to Riddell and Sparkle, the C.I.B.C. required and was given the following security:

(a) Guarantee of Riddell’s indebtedness by Sparkle;

(b) A demand debenture in the face amount of $300,000.00 as collateral to Sparkle’s guarantee;

(c) Assignments of the rental payments due under two leases on the premises owned by Sparkle which were rented to arm’s length parties;

(d) Guarantee of Sparkle’s indebtedness by Riddell;

(e) A general assignment of the book debts of Sparkle.

15. C.I.B.C. directed both tenants of the premises owned by Sparkle to make their rental payments directly to C.I.B.C. for Sparkle’s account.

16. The said tenants made such rental payments to the C.I.B.C.

17. Commencing in March 1978 and each month thereafter during the years under appeal, C.I.B.C. would take sufficient funds out of Sparkle’s bank account to pay Sparkles* (sic) and Riddell’s monthly principal and interest obligation to C.I.B.C. under their respective loans.

18. There was a bank account with the C.I.B.C. in the name of Sparkle but there was no bank account with the C.I.B.C. in the name of Riddell. However, Riddell and Sparkle had their own separate loan accounts at the C.I.B.C.

19. Commencing in March 1978 Sparkle’s financial statements have been prepared on the basis that all payments taken from Sparkle’s bank account have been applied solely to reducing the principal balance owing by Sparkle. No such amounts have been credited to reducing Riddell’s principal balance.

20. Sparkles’ (sic) financial statements for 1977 through 1980 indicate that the total interest incurred in those years with respect to Riddell's loan and Sparkles’ (sic) loan with the C.I.B.C. was deducted as an expense of Sparkle.

21. In Sparkles’ (sic) financial statements for the years under appeal, the loan payable is calculated as follows:

Riddell’s loan payable to bank

PLUS

Sparkle’s loan payable to bank

LESS

Shareholder loan receivable from Riddell.

22. During the years under appeal, no wages, dividends or management fees were paid by Sparkle to Riddell. Similarly, Riddell did not reimburse Sparkle for interest payments made by Sparkle on Riddell’s loan.

Riddell and an accountant (for Riddell and Sparkle) gave evidence.

The appellant contends that the Court should look through the corporate veil of Sparkle to reach the substance of the dealings of Sparkle and Riddell in that there was only one economic interest, namely, the building from which was derived rental income. He argues that Riddell had the same interest in this building as did Sparkle in that it was his original intention to buy the business as a going concern in 1973, but on advice of his lawyers and accountants, purchased all the outstanding shares of Sparkle in order to be able to deduct interest on loans needed to purchase the shares. It was further contended that Sparkle was a mere clone of Riddell and it was Riddell’s mind that controlled the company. In light of this, counsel for the appellant argued the doctrine of “constructive receipt” whereby the rental payments of the tenants which were paid directly to the bank were in reality received by Riddell. There was only one bank account in the name of Sparkle but there were two loan accounts: one in the name of Sparkle and one in the name of Riddell and the rental payments to the account of Sparkle were used by the bank to pay principal and interest on Sparkle’s as well as Riddell’s loan accounts. The appellant’s argument of “constructive receipt” on the basis that Riddell constructively received rental payments and applied them to his bank account fails in that rental payments were due to Sparkle and not to Riddell, though Riddell was the alter ego of Sparkle, no rental payments, at any time, were due to him but rather to the Company Sparkle. Any moneys paid on account of the loan of Riddell were entered into the financial statements as “shareholder’s loan account” until 1975. Thereafter it appeared in the financial statements as “bank charges and interest”.

The relevant sections of the Act to be considered are subsections 15(1) and (2) subparagraphs 20(1)(c)(i) and (ii) which read as follows:

15. (1) Where in a taxation year

(a) a payment has been made by a corporation to a shareholder otherwise than pursuant to a bona fide business transaction,

(b) funds or property of a corporation have been appropriated in any manner whatever to, or for the benefit of, a shareholder, or

(c) a benefit or advantage has been conferred on a shareholder by a corporation,

otherwise than

(d) on the reduction of capital, the redemption, cancellation or acquisition by the corporation of shares of its capital stock or the winding-up, discontinuance or reorganization of its business, or otherwise by way of a transaction to which section 88 applies,

(e) by the payment of a dividend or a stock dividend,

(f) by conferring on all holders of common shares of the capital stock of the corporation a right to buy additional common shares thereof, or

(g) by an action described in paragraph 84(1)(c.1) or (c.2), . . .

the amount or value thereof shall, except to the extent that it is deemed to be a dividend by section 84, be included in compting the income of the shareholder for the year.

(2) Where a person (other than a corporation resident in Canada) or a partnership (other than a partnership each member of which is a corporation resident in Canada) is a shareholder of a particular corporation, is connected with a share- holder of a particular corporation or is a member of a partnership, or a beneficiary of a trust, that is a shareholder of a particular corporation and the person or partnership has in a taxation year received a loan from or has become indebted to the particular corporation, to any other corporation related thereto or to a partnership of which the particular corporation or a corporation related thereto is a member, the amount of the loan or indebtedness shall be included in computing the income for the year of the person or partnership, unless

(a) the loan was made or the indebtedness arose

(i) in the ordinary course of the lender's or creditor’s business and, in the case of a loan, the lending of money was part of its ordinary business,

(ii) in respect of an employee of the lender or creditor or the spouse of an employee of the lender or creditor to enable or assist the employee or his spouse to acquire a dwelling for his habitation,

(iii) where the lender or creditor is a Corporation, in respect of an employee of the corporation to enable or assist the employee to acquire from the corporation fully paid shares of the capital stock of the corporation, or to acquire from a corporation related thereto fully paid shares of the capital stock of the related corporation, to be held by him for his own benefit, or

(iv) in respect of an employee of the lender or creditor to enable or assist the employee to acquire an automobile to be used by him in the performance of the duties of his office or employment,

and bona fide arrangements were made, at the time the loan was made or the indebtedness arose, for repayment thereof within a reasonable time; or

(b) the loan or indebtedness was repaid within one year from the end of the taxation year of the lender or creditor in which it was made or incurred and it is established, by subsequent events or otherwise, that the repayment was not made as part of a series of loans or other transactions and repayments.

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 properly (other than borrowed money used to acquire property the income from which would be exempt or to acquire a life insurance policy),

(ii) an amount payable for property acquired for the purpose of gaining or producing income therefrom or for the purpose of gaining or producing income therefrom or for the purpose of gaining or producing income from a business (other than property the income from which would be exempt or property that is an interest in a life insurance policy),

Mr. Justice Mahoney in J. Byke Estate v. The Queen, [1974] C.T.C. 763 at 767; 74 D.T.C. 6585 at 6588, nicely paraphrased paragraph 20(1)(c) (formerly paragraph 20(1(c)) as follows:

. . . The problem is that they did not pay the interest. The Company, which was not legally obliged to do so, did and they did not reimburse the Company.

Subparagraph 11(1)(c)(i) is not complete in itself; rather, subparagraph 11(1) (c)(i) must be read and construed as a whole. Arranged in a grammatically conventional order and edited of the alternatives not applicable in the circumstances, the section provides:

An amount paid in the year pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from property may be deducted in computing the income of a taxpayer in a taxation year.

The basic scheme of the Income Tax Act as it bears on a Canadian resident is to impose tax on that taxpayer’s income and not on anyone else’s income. Clearly the provisions of the Act that permit a deduction in the computation of that income are to be applied in the context of the basic scheme. Subparagraph 11(1)(c)(i) permits a deduction by the taxpayer who paid the interest and not by some other taxpayer. There are numerous ways in which a person can “pay" a sum but, in this case, the plaintiffs did not, in any way, pay the interest to the bank.

3. The interest on the deferred balance

. . . Again, it is helpful to strip that provision of inapplicable alternatives and to arrange it in a conventional order.

An amount paid in the year pursuant to a legal obligation to pay interest on an amount payable for property acquired for the purpose of gaining or producing income therefrom may be deducted in computing the income of a taxpayer for a taxation year.

Taken in the context of the basic scheme of the Act, it is clear that the deduction permitted by this section is also permitted only to the taxpayer who actually paid the interest. Again the plaintiffs did not; the Company paid this interest as well.

A taxpayer, in order to make use obexempting or deduction sections of the Act must come strictly within the wording of such provisions. Likewise, the Minister is so bound in assessing a taxpayer.

Throughout, Sparkle paid the interest and principal from its bank account on account of Riddell’s personal loan. There was no legal obligation upon Sparkle to make these payments in that they were the obligation of its sole shareholder — Riddell. Such payments constituted appropriation of company funds for the benefit of Riddell as its sole shareholder. No arrangements for repayment by Riddell were made nor in fact were any repayments made by Riddell. Repayments on behalf of Riddell by Sparkle were not charged to him as a shareholder.

A taxpayer is certainly entitled to arrange his affairs in such a way as to avoid taxation if he comes within the wording and spirit of the Act. Riddell, through his accountant, retained in 1976, set up the books of the Company with a view to avoiding tax. Unfortunately, he arranged them in the wrong way. For instance, the financial statements did not disclose the shareholder loan account. Consequently, Riddell cannot take advantage of the provisions of subsection 15(2). He was correctly assessed under subsection 15(1) as having received a benefit from Sparkle conferred on him as a shareholder. There is no need to pierce a corporate veil because the appellants did not seek not to disclose their purpose and intent. Rather, they were quite open about it. Their intent was clear.

Sparkle paid no dividends, salary or bonuses to Riddell. By payment of principal and interest on account of Riddell’s loan, it was a clear benefit conferred on him by Sparkle.

Sparkle sought to deduct, as a business expense, the payments that it made on account of Riddell’s interest payments on his loan. It had no legal obligation to do so and the appellant Riddell, in that the interest payments were made by Sparkle, is not entitled to the deduction under paragraph 20(1)(c) of the Act. The interest payments were made by another taxpayer, namely Sparkle. Simply, Sparkle cannot deduct the interest expense because it had no legal obligation to make such payments nor do such interest payments in any way relate to the rental business of Sparkle. On the other hand, Riddell cannot deduct interest payments as an expense because he did not, in fact, make such payments. In this case there is not even an attempt to evade tax but the taxpayers arranged their affairs in such a way as to attract taxation. The respondent had no alternative but to assess the appellants in the manner in which he did in that the wording of the relevant sections is quite clear. This results in one payment being taxable in the hands of one taxpayer and a non-deductible expense in the hands of the other who, in fact, made the payments. Mr. Justice Le Dain in Perrault v. The Queen, [1978] C.T.C. 395 at 402-3; 78 D.T.C. 6272 at 6277-78 said:

. . . It is once again the question whether, as a matter of principle, a single payment should be capable of being treated under different provisions of the Act as income in the hands of two taxpayers. Where the payment is received by one but has the effect of conferring a benefit on the other then it involves two distinct transfers or receipts, each of which may be subject to taxation on a separate basis. It is not being taxed twice in the hands of the same person. The appellant’s argument in essence is that the economy and spirit of the Act require that the payment be taxed once. I find nothing in the Act which dictates this result. The incidence of taxation depends on the manner in which a taxpayer arranges his affairs. Just as he may arrange them to attract as little taxation as possible, so he may unfortunately arrange them in such a manner as to attract more than is necessary.

For the above reasons, the appeals are dismissed.

Appeals dismissed.