Scott McKay, Ronald Heale v. Minister of National Revenue, [1984] CTC 2805, 84 DTC 1699

Tremblay, TCJ:—These appeals were heard on common evidence on May 17, 1984, at Sudbury, Ontario.

1. The Point at Issue

The point at issue is whether the appellants are correct in the computation of their income for the 1977 and 1978 taxation years to deduct amounts of interest paid to the bank on the capital of $255,000 borrowed in January 1977 and used the same month to purchase the shares of a numbered Ontario company.

The respondent disallowed the major part of the interest on the basis that the said shares were sold on June 27, 1977. The interests disallowed are those computed from the date of the disposition of the said shares, June 27, 1977.

2. The Burden of Proof

2.01 The burden is on the appellant to show that the respondent’s assessments are incorrect. This burden of proof results particularly from several judicial decisions, including the judgment delivered by the Supreme Court of Canada in Johnston v MNR, [1948] CTC 195; 3 DTC 1182.

2.02 In the same judgment, the Court decided that the assumed facts upon which the respondent based his assessments or reassessments are also deemed to be correct. In the present case, the assumed facts are described in the reply to notice of appeal as follows:

5. In reassessing the Appellant the Minister of National Revenue assumed, inter alia, the following facts:

(a) In January of 1977 the Appellant and Scott McKay purchased all of the shares of 348539 Ontario Limited with $255,000 borrowed from the Royal Bank of Canada;

(b) On June 27, 1977 the Appellant and Scott McKay sold all of their shares in the said corporation;

(c) Interest paid on the Royal Bank loan in the amounts of $5,826.00 in 1977 and $12,888.00 in 1978 after disposition of the shares was not paid on borrowed money used for the purpose of earning income from business or property.

3. The Facts

3.01 In January 1977, the appellants borrowed from the Royal Bank of Canada a sum of $255,000.

3.02 In January 1977, they purchased each 50 common shares and 125,000 preferred shares in the capital stock of 348,539 Ontario Limited, the object of which was restaurant business. The appellants paid $255,000.

3.03 To guarantee the loan of the appellants, the Royal Bank registered a mortgage against the chattels of the numbered company.

3.04 On June 27, 1977, the appellants sold their common shares to a Mr John Ellis. The same day, the numbered company redeemed the preferred shares of the appellants.

3.05 The chattels of the numbered company were delivered for the mortgage to the Royal Bank. A mortgage of $60,000 was registered in favour of the appellants.

3.06 At the same time, the Royal Bank registered a mortgage on the assets of Ronscott Inc to guarantee the loans of the appellants. The latter were the two sole shareholders of the said company, Ronscott Inc.

3.07 In October 1977, the numbered company became bankrupt, the chattels and other assets were sold to a new owner. The latter took three (3) years to reimburse the $60,000 to the appellants, ie in October 1980.

3.08 As part of Exhibit A-1, a Schedule of Loans and Loan Guarantees for the appellants from June 1972 to September 1980. It is as follows:

Scott McKay

Schedule of Loans and Loan Guarantees

	%
Owner- $			Date of
Company	ship	Amount	Transaction	Description
Espanola Hotel Limited 100		30,000	June 1, 1972	Direct loans to
				company from
				personal funds.
Espanola Hotel Limited 100		300,000	January 27, 1977	Guarantee of
				bank loan.
S M Hotel Holdings
Limited	100	125,000	June 1, 1974	Guarantee of
				bank loan.
Ronscott Inc	50	300,000	May 10, 1976	Guarantee of
				bank loan.
Ronscott Inc	50	150,000	November 3, 1977	Guarantee of
				Roynat loan.
Ronscott Inc	50	26,600	January 9, 1979	Guarantee of
				lease.
Ronscott Inc	50	150,000	April 9, 1981	Guarantee of
				Roynat loan.
348,539 Ontario Limited	50	255,000	January 15, 1977	Direct loan to
				company of funds
				borrowed from
				bank.
Igor Realty Inc	25	1,250,000	1978-79	Guarantee of
				bank loan.
Huscott Hotels Limited	100	81,400	September 16, 1980	Direct loan to
				company of
				funds borrowed
				from bank.
		R B Heale
Schedule of Loans and Loan Guarantees
	%
Owner-		$	Date of
Company	ship	Amount	Transaction	Description
Northern Life
Publishing Company
Limited	20	20,000	October 1, 1973	Guarantee of
				bank loan.
Norpoll Enterprises
Limited	100	310,000	January 27, 1977	Guarantee of
				bank loan.
Ronscott Inc	50	300,000	May 10, 1976	Guarantee of
				bank loan.
Ronscott Inc	50	150,000	November 3, 1977	Guarantee of
				Roynat loan.
Ronscott Inc	50	26,600	January 9, 1979	Guarantee of
				lease.
Ronscott Inc	50	150,000	April 9, 1981	Guarantee of
				Roynat loan.
348,539 Ontario Limited	50	255,000	January 15, 1977	Direct loan to
				company of
				funds borrowed
				from bank.
Igor Realty Inc	25	1,250,000	1978-79	Guarantee of
				bank loan.

4, Law—Cases at Law—Analysis

4.01 Law

The main provisions of the Income Tax Act invoked by the parties in this case are:

Sec 20(l)(c)

(c) Interest—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),

(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 from a business (other than property the income from which would be exempt or property that is an interest in a life insurance policy), or

(iii) an amount paid to the taxpayer under

(A) an Appropriation Act and on terms and conditions approved by the Treasury Board for the purpose of advancing or sustaining the technological capability of Canadian manufacturing or other industry, or

(B) The Northern Mineral Exploration Assistance Regulations made under an Appropriation Act that provides for payments in respect of the Northern Mineral Grants Program,

or a reasonable amount in respect thereof, whichever is the lesser;

Sec 20(1)(p)

(p) Bad debts—the aggregate of debts owing to the taxpayer

(i) that are established by him to have become bad debts in the year, and

(ii) that have (except in the case of debts arising from loans made in the ordinary course of business by a taxpayer part of whose ordinary business was the lending of money) been included in computing his income for the year or a previous year;

Sec 54

(c) "Disposition” of property—“disposition” of any property, except as expressly otherwise provided, includes

(i) any transaction or event entitling a taxpayer to proceeds of disposition of property,

(ii) any transaction or event by which

(A) any property of a taxpayer that is a share, bond, debenture, note, certificate, mortgage, hypothec, agreement of sale or similar property, or an interest therein, is redeemed in whole or in part or is cancelled, . . .

4.02 Cases at Law

The parties referred the following cases at law and jurisprudence to the Court:

A — Interpretation of 20(l)(c):

1. Lyle A Meredith v The Queen, [1975] CTC 570; 75 DTC 5412

2. Trans-Prairie Pipe Lines v MNR, [1970] CTC 537; 70 DTC 6351 3. PE Deschenes v MNR, [1979] CTC 2690; 79 DTC 461

B — Use or Effect of the Use of Borrowed Money:

4. Phyllis Barbara Bronfman Trust v The Queen, [1983] CTC 253; 83 DTC 5243 5. Articles commenting Bronfman case.

C — Nil Assessment:

1. Stringam Farms v MNR, [1977] CTC 2438; 77 DTC 317

2. The Queen v Garry Bowl Ltd, [1974] CTC 457; 74 DTC 6401. 4.03 The Appellants' Contentions

4.03.1 The appellants in their submission pointed out the following arguments:

(a) Pursuant to 20(l)(c), the interest must be deducted not only for 1977 and 1978 tax but at least until 1980 when the mortgage due by the new owner of the restaurant was completely paid (para 3.07).

(b) The second argument is that the redemption of the preferred shares is not a disposition of property and therefore paragraph 20(1 )(c) still applies.

(c) The third argument of the appellants is that if 20(l)(c) does not apply, provision 20(l)(p) quoted above, must apply because they made loans in the ordinary course of business.

(d) Finally, if provisions 20(l)(c) and (p) do not apply, they contend that the fundamental principle involved in the Bronfman case applies in the instant case.

4.03.2 Interest “wholly” applicable to the property purchased with the borrowed money

The answer concerning the main argument that the expense interest on the borrowed money was applicable to another source of income other than the shares purchased with the borrowed money, is in section 20(l)(c) quoted above. Several times, the courts have given decisions on the interpretation of 20(l)(c). The reference to some precedents are given above.

In the instant case, pursuant to the evidence, the shares were the property acquired with the borrowed money in January 1977. They were sold on June 27, 1977. The shares being sold cancelled the income from that source. Indeed there was not even a source, therefore after that date of June 27, 1977 it is not possible to include the interest in the computation of the income from the shares and the said interest cannot be deducted from any other source of income.

In Trans-Prairie Pipelines Ltd v MNR, Jackett, P, of the former Exchequer Court stated the following, at 541 [6354]:

Surely, what must have been intended by Section 1 l(l)(c) (20(l)(c) of the new Act) was that the interest should be deductible for the years in which the borrowed capital was employed in the business rather than that it should be deductible for the life of the loan as long as its first use was in the business.

In Meredith, (supra), at 578 [5417]), Mr Justice Cattanach, on another aspect, arrives at the same conclusion as Mr Justice Jackett:

With respect to the deduction of the interest paid by the plaintiff on the bank loan, the money was borrowed by the plaintiff to acquire the property, to create the ponds and to install the equipment necessary to operate the business. He was under a legal obligation to repay the principal and to pay the interest thereon. However a cardinal rule of interpretation of a statute is that the statute speaks from the present unless the context requires otherwise. Section 1 l(l)(c)(i) or the Income Tax Act quoted above permits the deduction in computing income for a particular year an amount paid in the year pursuant to a binding legal obligation to pay interest on “borrowed money used for the purpose of earning income from a business or property’’. Income tax is an annual affair. While the obligation to pay the interest on the loan continued throughout the plaintiffs 1969 taxation year, the money borrowed was not being used in that year for the purpose of producing income from a business in that year. With reluctance, therefore, I conclude that consequent upon section 11(1)(c) the deduction of the interest is also precluded.

4.03.3 The mortgage on the chattels to guarantee the payment of $60,000 was not the property acquired by the appellants with the borrowed money in January 1977, the said property was the shares. Since June 27, 1977, they have not been owned by the appellants. The same reasoning applies for the mortgage registered by the Royal Bank on the Assets of Ronscott Inc (para 3.06).

4.03.4 Redemption of Preferred Shares: a Disposition of Property

Concerning the argument that the redemption of preferred shares is not a disposition of property, the answer is in subparagraph 54(c)(ii)(A), of the Income Tax Act, quoted above. The key words are “the disposition of any property . . . includes any transaction . . . by which any property of a taxpayer that is a share, . . . is redeemed . . .” It is obvious, therefore, that even the preferred shares were also disposed of on June 27, 1977 and hence that the interest provided in 20(l)(c) cannot apply concerning the shares.

4.03.5 Interpretation of 20(l)(p)

The argument concerning 20(1 )(p), quoted above to the effect that the appellants, in the ordinary course of their business, lend money cannot stand.

The testimony of Mr Heale and the excerpt of Exhibit A-l quoted above in paragraph 3.08, rather prove that the appellants borrowed money instead of lending money.

It is true that a few times, Mr Heale referring to the purchase of shares of the numbered company, said they lent it money. They invested in the said company in purchasing shares but did not lend it money. There is no evidence to this effect. Moreover there is no evidence that the other loans listed in A-l were money lent by the appellants to other persons.

4.03.6 Bronfman Trust Case

The facts of the Bronfman Trust case were referred to in the above. This case and the decision of the Federal Court of Appeal are summarized as follows in [1983] CTC 253; 83 DTC 5243:

The taxpayer, a trust, made allocations of capital to the beneficiary of the trust in 1969 and 1970. Instead of selling part of its income-producing portfolio of securities in order to make the allocations, the taxpayer borrowed the funds it required. It then claimed deductions for the interest paid on the loans in 1970, 1971 and 1972. The Minister disallowed the deductions on the ground that the interest expense was not incurred for the purpose of earning income. The taxpayer appealed unsuccessfully to the Tax Review Board (78 DTC 1752) and then to the Federal Court — Trial Division (79 DTC 5438) claiming that the loans were deemed to have been used to earn income since their use allowed the taxpayer to retain securities which produced income and which increased in value before the loans were repaid. The Federal Court — Trial Division dismissed the taxpayer’s appeal, observing that no money had actually been added to the taxpayer’s income-producing capital, and concluding that the borrowed money was not used to earn income from property. The taxpayer appealed to the Federal Court of Appeal.

Held: The Taxpayer’s appeal was allowed. In a majority judgment, the Court decided that by borrowing money and using it to pay the allocations, the trustees preserved the income-producing capacity of the trust’s investments. That was sufficient in the circumstances to characterize the borrowed money as having been used for the purpose of earning income from the trust property. Attention was not to be focused on the use of the borrowed money to pay the capital allocations. What was important was the effect of such use of borrowed funds. That effect was to preserve the income-generating capacity of the trust assets. The money was borrowed for the purpose of gaining or producing income from the trust property. The interest payments were therefore deductible and the taxpayer's appeal was allowed.

The appellants’ argument, as I understand it, is that they preferred in June 1977 to continue to finance with other assets, the loan made in January 1977 from the Royal Bank, rather than to sell shares of companies they owned or to sell assets they owned. In doing this, they preserved intact their income capacity as the Bronfman Trust did. It is the effect which is important.

The general principle involved in the Bronfman Trust seems to be a general principle of business and must be treated as such, on the same level as a general principle of accounting, or a general principle of law in interpreting the Income Tax Act. They all apply inasmuch as there is no specific provision in the Act stipulating to the contrary. It is my opinion that provision 20(1 )(c) prevents the application of all other general principles to permit the deduction of the interest expense of borrowed money from the Royal Bank in the computation of a source of income other than the shares of the numbered company, which are the property purchased with the borrowed money in January 1977. Whereas the said shares were sold on June 27, 1977, there was no further source of income from the borrowed money.

4.03.7 Nil Assessment

As alternative argument, the respondent contended that whereas the 1978 assessment of the appellant McKay was a nil assessment, the appeal concerning that year had to be dismissed anyway. Counsel for the respondent referred to the Gary Bowl and Stringam Farm cases, (supra), (para 4.02).

The Court agrees with the respondent’s contention that there is no possibility to appeal from a nil assessment. Indeed, there is no possible change in such assessment, even if the appeal were allowed. When an appeal is allowed, it must lead to a change of the assessment under appeal.

5. Conclusion

The appeals are dismissed in accordance with the above reasons for judgment.

Appeals dismissed.