Garneau Marine Co LTD v. Minister of National Revenue, [1982] CTC 2191, 82 DTC 1171

D E Taylor:—This is an appeal heard in Edmonton, Alberta on February 8, 1982, against income tax assessments in which the Minister of National Revenue disallowed deductions claimed as interest expenses in the amounts of $2,905.56 and $10,216.03 respectively for the years 1977 and 1978. Robert L Thompson and Evelyn M Thompson, were the two principal shareholders of Garneau Marine Co Ltd (“Garneau”). Garneau had also lodged appeals with the Board against income tax assessments for the same years in their personal returns. Counsel for the appellant requested that the appeals of Robert Thompson and Evelyn Thompson be heard on common evidence and the decision rendered in that way, but that the appeal of “Garneau” be treated separately.

Counsel for the respondent was of the view that the three appeals should be heard together on common evidence but the Board accepted the request of counsel for the appellants, heard the evidence and argument related to the two Thompson appeals first, and reserved decision thereon. The hearing of the instant appeal followed.

The sole witness in the two Thompson appeals was Robert L Thompson who identified himself as president of Garneau. In order to avoid calling Mr Thompson a second time, it was agreed between counsel that the testimony of Robert Thompson in his own appeal would be applicable to the Garneau appeal to whatever degree considered relevant by the Board. It was not made clear to the Board in what manner that end result differed from hearing all three appeals on common evidence, but it was the procedure adopted. In assessing the company, the Minister relied, inter alia, upon section 3, subsection 9(1) and paragraph 20(1 )(c) of the Income Tax Act, SC 1970-71-72, c 63, as amended, and on the following assumptions

(a) in 1977 a shareholder’s loan of $150,000 was made by Garneau to Robert and Evelyn Thompson to purchase their principal residence;

(b) the loan was made through four payments as follows:

(c) on June 22, 1977, Garneau borrowed from the Bank of Montreal the sum of $100,000 with fixed payments of $825 per month plus interest.

(d) arrangements were made between Garneau and Mr and Mrs Thompson to repay the shareholder’s loan of $150,000 on the basis of $825 a month ($10,000 a year, $5,000 for each shareholder) without interest charges.

(e) Garneau deducted the interest expense paid to the Bank of Montreal in computing its taxable income in the amount of $2,905.56 in its 1977 taxation year and the amount of $10,216.03 In its 1978 taxation year.

Contentions

The appellant contended that:

— the loan made to it by the Bank of Montreal on June 22, 1977 constituted borrowed money which was in fact used for the purpose of earning income from a business, and that

— the amounts of $2,905.56 and $10,216.03 paid by the appellant in respect of interest in its 1977 and 1978 taxation years respectively, were paid by the appellant pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from business and were proper deductions under the provisions of subparagraph 20(1 )(c)(i) of the Income Tax Act.

The respondent contended that:

— the interest amounts were not paid on borrowed money used for the purpose of earning income from a business or property within the meaning of subparagraph 20(1 )(c)(i) of the Act.

Evidence

In his testimony Mr Thompson agreed that indeed the $100,000 referred to above had gone into the purchase of his residence, and stated that the balance of some $50,000 to make up the total of the $150,000 amount had come from the regular operating funds of the company. The company’s bank was the Bank of Nova Scotia but at the time the funds were required by him, the credit limit had been reached and, to avoid delay in getting that credit limit raised, he had borrowed (in the company name) the $100,000 from the bank where he did his personal banking — the Bank of Montreal. The $100,000 had been deposited in the Bank of Nova Scotia, the company’s business bank account on June 22, 1977 and on the same day, the cheque in the amount of $116,200 noted earlier had been issued to his wife and himself as part of the $150,000 loan from the company. Mr Thompson filed with the Board the promissory notes which had been prepared between the company as lender, and his wife and himself as borrowers. Their “bona tides" had not been challenged by the Minister other than the fact that no interest was being paid on the loan from the company to the Thompsons, whereas the company was paying interest on the loan from the Bank of Montreal.

Mr George Hawken, the accountant and comptroller of Garneau, recited the history of the loans and pointed out that, immediately after paying the $116,200 to the Thompsons, the company had retired its own outstanding bank loan in the amount of $140,000. It was not possible for him to determine with certainty that the $100,000 from the Bank of Montreal had gone to pay part of the $116,200 loan to the Thompsons, or to the retirement of the bank loan — both transactions had taken place in the regular company bank account at about the same time. Under cross-examination, Mr Hawken agreed that at the time in question the company’s line of credit was $250,000, that before the deposit of the $100,000 from the Bank of Montreal there had been the $140,000 bank loan to the company from the Bank of Nova Scotia, and an operating overdraft of some $97,407, leaving only $12,593 available as credit. In addition, while the $140,000 had been paid to the Bank of Nova Scotia on June 22, 1977, the company had been required to take out a new bank loan of $250,000 at the same time in order to do that and wipe out the overdraft. Counsel for the Minister filed with the Board the Bank of Nova Scotia bank statements covering the period June 3, 1977 to June 24, 1977 which gave details regarding the above transactions. These bank statements also show that by June 24, 1977, after the $250,000 loan noted above, the company had a new bank overdraft of $36,682.

Argument

Counsel for the appellant argued that since the $100,000 Loan from the Bank of Montreal had gone through the company’s business bank account and payments other than the $116,200 loan had also been made (particularly the retirement of the $140,000 bank loan), it was impossible to isolate the transactions in such a way that the Minister’s assumption was applicable — it was just as logical that the amount had been used in the company business and some other funds, presumably regular company operating funds, had been taken out of the business bank account to make the loan of $116,200.

Counsel for the respondent disagreed, and noted that according to the bank statements filed with the Board after payment of the $116,200, but before retirement of the $140,000 loan, a bank overdraft of some $50,000 had existed. It was emphasized by counsel that the Minister was not attributing any calculated form of interest charge to the $50,000 allegedly provided to the Thompsons out of the regular operating funds of the company on the basis that the Act did not require, during the taxation years in question, that interest be charged on shareholders’ loans. As a matter of fact, no interest was demanded or charged by the company on the total of $150,000 of shareholders’ loans in this matter, and the point of whether or not it all represented company funds or borrowed funds was not really at issue according to counsel. The point of the dispute was that the company had borrowed the $100,000 given an interest-bearing obligation to the Bank of Montreal in return, but then loaned the funds to the Thompsons and received non-interest-bearing promissory notes for value. These non-interest-bearing promissory notes represented a “property” under the Income Tax Act and, because of subsection 15(2), they were considered by the Minister in the particular circumstances of this case as adequate proof and security for the debts. There was no objection from the Minister that other conditions in subsection 15(2) of the Act had generally been fulfilled by the Thompsons, but the Minister objected to the fact that the interest obligation to the Bank of Montreal should be treated as a deductible expense by the company since there was no indication that the “property” (the promissory notes) could ever produce income.

Counsel cited as support for the Minister’s position the cases of Joel Sternthal v The Queen, [1974] CTC 851; 74 DTC 6646 and Phyllis Barbara Bronfman Trust v The Queen, [1979] CTC 524; 79 DTC 5438.

Findings

The $100,000 borrowed by this appellant company from the Bank of Montreal and put into the company bank account, went directly out of that bank account in the form of a loan to the Thompsons. There was no other $100,000 available with which to negotiate the payment of the loan of $116,200 to the Thompsons on the same day. The “borrowed funds” from the Bank of Montreal were not used in the company business in any manner to earn income, but rather were used to produce a property, the non-interest-bearing promissory notes from which no income could be produced. In fact, other than as an “in and out” entry in the company bank account, the promissory notes did not enter into the company operations at all. The interest cost of money borrowed, when used in such a manner (not to produce income), is not deductible under paragraph 20(1 )(c) of the Income Tax Act.

Decision

The appeal is dismissed.

Appeal dismissed.