David H Hill v. Minister of National Revenue, [1981] CTC 2120, [1981] DTC 167

The Chairman:—The appeal of Mr David H Hill is from an assessment by which the Minister of National Revenue deleted from the appellant’s 1975 tax return interest income, interest expenses, interest income deduction and the capital loss claimed relative to the acquisition and disposition of certain bonds.

The allegations of facts as stated by the appellant in his notice of appeal are as follows:

1. It is alleged by the Minister of National Revenue in the explanation attached to the notice of re-assessment dated March 1, 1977 for the taxation year 1975 that the interest income, interest expenses, interest income deduction and capital loss as indicated in the income tax return of David H Hill for the taxation year 1975 should have been deleted because “it is not considered that the investment (to which those items related) was made for the purpose of producing income.

2. The investment was the acquisition and disposition of $16,000 in principal face amount of Union Carbide Canada Ltd bonds.

3. The facts with respect to the acquisition and disposition by David H Hill of Union Carbide Canada Ltd bonds are as follows:

(a) In the autumn of 1975 David H Hill was contacted by a group who were in the process of investing in Union Carbide Canada Ltd bonds with the suggestion that he participate in the investment. Although it was indicated that some members in the investment group would dispose of the investment shortly after it was acquired for income tax purposes it was clearly an option that the investment did not have to be disposed of and could be held for investment purposes;

(b) David H Hill committed to make an investment as part of the investment group in the Union Carbide Canada Ltd bonds in early November of 1975. At that time there was no instruction by David H Hill to the investment group to dispose of his investment and his intention was to make this investment on a normal investment basis and not only for income tax purposes;

(c) The investment by David H Hill was completed either on the date when it was expressed to have taken effect in the records of the stockbroker, that is December 11, 1975, or on the due date for payment to the stockbroker, that is December 12, 1975;

(d) The cost of this investment was paid by David H Hill by delivering his personal cheque to the stockbroker through which the investment was made, the cheque being dated December 24, 1975, in the amount of $16,594.08 composed of $15,760 of principal and $834.08 of accrued interest;

(e) During the months of November and December of 1975 the personal situation of David H Hill altered substantially. He and his wife, who was a teacher, were separated and David H Hill no longer had available the income of his wife as a contribution to family income. These changed financial circumstances of David H Hill resulted in his decision to dispose of the investment in the Union Carbide of Canada Ltd bonds;

(f) David H Hill issued instructions to a stockbroker to dispose of his investment in the Union Carbide of Canada Ltd bonds on December 15, 1975 and the stockbroker completed the sale on that same date;

(g) The proceeds of the disposition of this investment were turned over to David H Hill by the issuance of a cheque in his favour by the stockbroker through which the investment was disposed of;

(h) By notice of re-assessment dated March 1, 1977 addressed to David H Hill for the taxation year 1975, an adjustment of $385.25 was added to the previous amount assessed under the Income Tax Act and by a notice dated April 22,

1977, a further amount of $2.42 for interest was levied. The notice of reassessment deleted interest income, interest expenses, interest income deduction and capital loss from the calculation of income tax payable by David H Hill for the taxation year 1975.

The assumptions on which the Minister based his assessment, as contained in the reply to the notice of appeal, are as follows:

(a) Greenshields Incorporated (“Greenshields”) bought and sold Union Carbide Canada Ltd bonds maturing June 15, 1995, in December of 1975 (the “Union Carbide Bonds”);

(b) Greenshields did not purchase the Union Carbide bonds on behalf of the appellant;

(c) the Union Carbide bonds were not assigned or transferred to the appellant;

(d) the appellant did not become entitled to interest from Union Carbide bonds;

(e) no interest from the Union Carbide bonds were receivable by the appellant in 1975; and

(f) there was no bona fide acquisition or disposition of the Union Carbide bonds on the part of the appellant.

Submissions by the Appellant:

1. The Union Carbide Canada Ltd bonds were acquired by David H Hill as a bona fide investment for the purpose of producing income at a cost which included an interest expense in the amount of $834.08. This interest expense was a proper deduction under paragraph 20(1 )(c) of the Income Tax Act. At the time the commitment for acquisition was made, there was no immediate intention to dispose of the investment.

2. The personal and financial situation of David H Hill which began to develop at the time of the commitment for this investment was such that David H Hill could not support this investment and that situation was clear at the time the investment had to be paid for. Accordingly, when David H Hill was notified by the stockbroker of required payment, he gave the stockbroker instructions to dispose of the investment. These instructions were issued December 15, 1975 and the bonds were disposed of on that date and this was a bona fide disposition. The proceeds of the disposition of the Union Carbide of Canada Ltd bonds were paid to David H Hill by a cheque issued by the stockbroker.

3. Upon the disposition of this investment, David H Hill received $850.63 as interest and these funds were actually received by him as being included in the cheque issued by the stockbroker to him as part of the proceeds of the disposition and it was not merely the right to interest which he received. Accordingly that interest was properly income of David H Hill under subsection 12(1 )(c) of the Income Tax Act and properly entitled David H Hill to a deduction as interest eligible for interest and dividend income deduction under subsection 110.1(1) of the Act.

4. Upon the disposition, David H Hill suffered a capital loss of $80 within the meanings of sections 38 and 39 of the Act.

Submissions by the Respondent:

4. He relies, inter alia, on sections 3, 38, 39 and 110.1, subsections 9(1) and 20(14) and upon paragraphs 12(1)(c) of the Income Tax Act, RSC 1952, c 148 as amended by section 1, c 63 of SC 1970-71-72.

5. He submits that the Union Carbide bonds were not assigned or transferred to the appellant within the meaning of subsection 20(14) of the Income Tax Act, nor was the appellant entitled to interest within the meaning of the said subsection 20(14), and that therefore the appellant could not make a deduction pursuant to that subsection.

6. He further submits that no interest from Union Carbide bonds was receivable by the appellant in 1975 within the meaning of paragraph 12(1 )(c) of the Income Tax Act, and that therefore the appellant was not entitled to a deduction pursuant to paragraph 110.1 (1 )(b) of the Income Tax Act.

7. He further submits that the Union Carbide bonds were not disposed of by the appellant within the meaning of paragraph 39(1 )(b) of the Income Tax Act inasmuch as said bonds were never his to dispose of, therefore the appellant is not entitled to claim an allowable capital loss in his calculation of income pursuant to paragraph 3(e)(i) of the Income Tax Act.

Findings:

In recent years the Board has rendered consistent decisions in cases such as the instant appeal arising from the interpretation and application of sub- paragraph 3(e)(i), paragraph 12(1)(c), subsection 20(14), paragraphs 39(1 )(b) and 110.1 (1 )(b) of the Income Tax Act, SC 1970-71-72, c 63, as amended, some of which are found in the book of authorities provided to the Board by the respondent in support of his position in this appeal.

Although reasons for judgments may differ from one case to another, depending on the facts, a very valid series of guidelines if not principles have developed from the Board’s jurisprudence in dealing with what has now become commonly known as “bond flip” cases.

For purposes of this appeal, the appellant’s allegations that he committed himself as part of an investment group to make an investment in Union Carbide Canada Ltd bonds in November 1975 is, in my opinion, immaterial to the issue. The appellant testified that, owing to marital troubles, he had forgotten his commitment until reminded of it by the stockbroker. The income of the appellant’s wife no longer being available to the appellant, he alleges to have then decided to dispose of the bonds.

The appellant, in his notice of appeal, states that his instructions to the brokers, Greenshields Incorporated, to dispose of the bonds was given on December 15, 1975. The broker’s purchase order dated December 12, 1975 is in the amount of $16,594.08, Exhibit A-1; the sale order dated December 16, 1975 is in the amount of $15,684.71, Exhibit A-2, and the appellant’s cheque to Greenshields dated December 24, 1975 is in the amount of $16,594.08, exhibit A-3. The summary of the appellant’s investment issue for 1975 was filed as Exhibit A-4.

The evidence is unclear as to whether the bonds were bearer bonds or registered bonds. If the latter, there is no evidence of any bonds having been registered to the appellant, nor is there any evidence that the bearer bonds were physically transferred or assigned to the appellant.

In his 1975 tax return, the appellant included in his return the amount of $850.63 as interest income under paragraph 12(1 )(c) of the Act; he deducted an interest expense of $834.08 under paragraph 20(1 )(c) of the Act; he claimed a deduction of $1,000 for interest and dividend income under subsection 110.1(1) of the Act and claimed a capital loss of $80. pursuant to sections 38 and 39 of the Act. In assessing the appellant, the Minister deleted the appellant’s interest income and disallowed the interest expenses, the interest and dividend income deduction as well as the capital loss.

One of the keys to the present issue is to be found in the case of Frank Tyrala v MNR, [1978] CTC 2905; 78 DTC 1659, the pertinent facts of which are not distinguishable from the facts of the instant appeal.

In that case, the Presiding Chairman, Mr Delmer E Taylor, CA, stressed the point that what the taxpayer had paid for and what he received from the transaction on the disposition of the bonds was not interest within the meaning of paragraph 12(1 )(c) of the Act.

Paragraph 12(1 )(c) reads as follows:

(c) Interest.—any amount received by the taxpayer in the year or receivable by him in the year (depending upon the method regularly followed by the taxpayer in computing his profit) as, on account or in lieu of payment of, or in satisfaction of, interest;

Whether what was allegedly purchased and sold by the appellant was merely the right to interest when due and payable, whether it was the overall price of the bonds themselves at their then market value which had increased by an amount equal to the interest which had accrued in favour of the previous holder of the bonds for whom it clearly was interest income, or whether the payment of $850.63 was something else, it was not in my opinion for the appellant an amount received on account, or in lieu of payment of or in satisfaction of interest owing to the appellant within the meaning and intent of paragraph 12(1 )(c) of the Act. The Minister did not err therefore in deleting $850.63 as interest income from the appellant’s 1975 tax return, notwithstanding the wording of Greenshields’ summary of the appellant’s investment in qualifying the amount of $850.63 as eligible interest from Canadian sources, exhibit A-4.

The appellant relied on paragraph 20(1 )(c) of the Act in deducting from his income an amount of $834.08 as an amount paid pursuant to a legal Obligation to pay interest on borrowed money used to earn income from property.

Paragraph 20(1 )(c) reads as follows:

(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;

Whatever may have been the appllant’s declared intention in November 1975, according to his own testimony, he placed a sale order with Greenshields even before having legally acquired the bonds. It is difficult to understand: first, how the appellant expected to earn interest income from the purchase of the bonds at a price of $16,594.08 which he paid on December 24, 1975, Exhibit A-1, for bonds whose value on December 16, 1975, the date of sale, was $15,684.71, Exhibit A-2; secondly, what loan did the appellant make on which he was legally obligated to pay interest. There is no evidence that the appellant had contracted a bank loan to meet the cost of the bonds, nor is there any evidence that Greenshields made a loan to the appellant for which the latter was legally obligated to pay interest.

On what basis therefore can the appellant deduct $834.08 as an interest expense?

I find that the facts of the present appeal do not meet the requirements of paragraph 20(1 )(c) of the Act, because it is an exemption section and must be interpreted restrictively. Since no interest was paid by the appellant on a loan made by him for the purpose of gaining income, paragraph 20(1 )(c) of the Act is not applicable and the Minister properly disallowed the interest expense claimed.

The evidence forces me to conclude that what we have here is a classic example of so-called bond flip transactions, the very nature of which and indeed their ultimate purpose and use do not come within either the wording or the intent of the legislators in drafting the exemption provisions of section 110.1 of the Act, nor do they meet the requirements of subsection 20(14) of the Act.

Section 110.1 of the Act reads as follows:

Interest and dividend income deductible.

(1) For the purpose of computing the taxable income for a taxation year of an individual (other than a trust that is not a testamentary trust within the meaning assigned by paragraph 108(1 )(i) ), there may be deducted from his income for the year an amount equal to the lesser of

(a) $1,000, and

(b) the aggregate of

(i) the amount of interest included in computing the taxpayer’s income for the year, and

(ii) the taxpayer’s grossed-up dividends for the year.

In my opinion the incentive offered taxpayers by section 110.1 of the Act in permitting the deduction of interest income up to a maximum of $1,000 applies only to current inerest i.e. interest earned by the taxpayer in the taxation year in which the deduction is made.

For reasons already stated, I do not consider that the appellant earned any interest income in the pertinent taxation year and no deduction is permissible under section 110.1 of the Act.

Subsection 20(14) of the Act deals exclusively with the transfer of accrued interest.

Subsection 20(14) reads as follows:

Accrued bond interest. Where, by virtue of an assignment or other transfer of a bond, debenture or similar security (other than an income bond or an income debenture), including for greater certainty an assignment or other transfer after June 18, 1971 of a bill, note, mortgage, hypothec or similar obligation, the transferee has become entitled to interest in respect of a period commencing before the time of transfer and ending after that time that is not payable until after the time of transfer, an amount equal to that proportion of the interest that the number of days in the portion of the period that preceded the day of transfer is of the number of days in the whole period

(a) shall be included in computing the transferor’s income for the taxation year in which the transfer was made, and

(b) may be deducted in computing the transferee’s income for a taxation year in the computation of which there has been included

(i) the full amount of the interest under section 12, or

(ii) a portion of the interest under paragraph (a).

The evidence in the instant appeal did not establish whether the subject bonds were bearer bonds or registered bonds; there is no evidence that any bonds were registered in the appellant’s name and no evidence whatever that there had been a physical transfer or assignment of the bonds to the appellant.

The Board has also consistently considered the physical transfer and the assignment as well as the legal ownership of the bonds to be necessary conditions for the taxpayer to be successful in meeting the requirements of subsection 20(14) of the Act. (K D Wollin v MNR, [1979] CTC 2826; 79 DTC 689; Ralph W Goldsilver v MNR, [1979] CTC 2809; 79 DTC 694; Frederick Tim Smye v MNR, [1980] CTC 2372; 80 DTC 1326.

In my Opinion, as important as is the evidence of the physical transfer and the assignment of the bonds to the transferee before subsection 20(14) of the Act can be properly applied, so too is evidence that the transferor has included the accrued interest in his income for the year in which the transfer was made before the transferee can rightly deduct from his income the same amount of interest that had accrued to the transferor up to the date of the transfer. There is no evidence that, at the time, the bonds were allegedly transferred or assigned to the appellant that the transferor had included in his income the interest earned by him up to the date of transfer which, as I read paragraph 20(14)(a) of the Act, is mandatory. What I find to be contrary to the provisions of subsection 20(14) of the Act is that the taxpayer in acquiring and in disposing of the bonds within a very short period of time, confers upon himself simultaneously the role of both the transferor and transferee of the bonds in each of the transactions. This sort of artificial blending of the role of transferor and transferee by the taxpayer in the acquisition and disposition of bonds in bond flip cases does not, in my view, come within the wording and the meaning of the interest of subsection 20(14) of the Act.

Lastly the appellant relies on sections 38 and 39 of the Act to claim a capital loss of $80 resulting from his disposition of the bonds.

Paragraph 39(b) of the Act reads as follows:

(b) a taxpayer’s capital loss for a taxation year from the disposition of any property in his loss for the year determined under this subdivision (to the extent of the amount thereof that would not, if section 3 were read in the manner described in paragraph (a) of this subsection, be deductible in computing his income for the year or any other taxation year) from the disposition of any property of the taxpayer other than

(i) depreciable property, or

(ii) property described in subparagraph (a)(i), (ii) or (iii).

Before paragraph 39(b) of the Act can apply, it is necessary that the property disposed of on which a loss is sustained must be owned by the taxpayer. In the instant appeal the appellant’s actual ownership of the bonds and his legal rights to them on the dates they were allegedly acquired and disposed of, is a very questionable point. The appellant had, according to his evidence, forgotten that he had agreed as a member of a group to purchase Union Carbide Bonds and had to be reminded by his brokers of his commitment. At that time, the appellant could no longer financially afford to purchase the bonds and placed a sale order with the brokers. The bonds were allegedly sold on December 16, 1975, but were paid for by cheque by the appellant on December 24, 1975.

Contrary to what the appellant, a lawyer, suggested in argument, the burden of confirming the nature of the bonds, of proving that the bonds were physically transferred to him or registered in his name, as well as establishing the ownership of the bonds at the date of the sale rests squarely on the appellant. The appellant failed to establish to the satisfaction of the Board that on December 16, 1975, the date of sale of the bonds, that he was the legal owner of the bonds or that he had any legal rights to them. Without that evidence, the Board cannot conclude that the appellant sustained any loss on the disposition of the bonds.

For these reasons, the appeal must be dismissed.

Appeal dismissed.