Ludmer v. Minister of National Revenue, (sub nom. Ludco Enterprises Ltd. v. R.) 98 D.T.C. 6045, [1998] 2 C.T.C. 104

Lutfy J.:

1 The plaintiffs invested $7.5M to acquire shares of Justinian Corporation S.A. and Augustus Corporation S.A., both incorporated under the laws of Panama.The business activity of the two companies was to invest in Canadian and United States dollar denominated fixed income securities. The shares were acquired in five separate transactions between September 1977 and June 1979. None of the shares was disposed of until 1985. The plaintiffs borrowed $6.5M to finance their share acquisitions. While they held these shares, the plaintiffs incurred interest costs of $6M and earned dividends of $0.6M. Upon the disposition of their shares in 1985, the plaintiffs reported capital gains of $9.2M.

The issues

2 The plaintiffs seek to deduct their interest costs against other reported income for the taxation years 1981 through 1985. In their view, their interest expense of $6M incurred to earn the dividend payments of $0.6M is deductible because: (a) the dividends are income from a business or property within the meaning of sub-paragraph 20(1)(c)(i) of the Income Tax Act and the test is income, not profit or net income; and (b) even if the test is profit, the plaintiffs had a reasonable expectation in 1977 that (i) the dividends would eventually exceed the interest expense or (ii) the dividends together with the gains on disposition would result in the profit which was in fact realized.

3 The defendant disagrees. Justinian's annual dividend was always US$1. The defendant characterizes the total dividend payments, when compared to the interest costs, as “nominal”, “small” or “very low”. For the defendant, the real purpose of the plaintiffs' investments with borrowed funds was to allow Justinian's earnings to accrue and, upon the eventual disposition of the shares, the taxation of their profits would be limited to capital gains treatment. In the defendant's view, the borrowed funds were not used for the purpose of earning income from a business or property and the plaintiffs never had a reasonable expectation of profit from the dividend payments.

4 Assuming the defendant's theory that their investments in Justinian were made solely to realize capital gains, the plaintiffs argue, in the alternative and quite summarily, that their transactions can only be characterized as an adventure in the nature of trading. In this circumstance, the interest expenses are deductible as having been incurred on loans used to generate business income.

5 Finally, concerning the defendant's reliance on section 245, the plaintiffs submit that the defendant failed to establish that the interest expenses were incurred in respect of artificial transactions which unduly or artificially reduced their income.

The proceedings

6 The defendant issued new assessments disallowing the deductibility of the plaintiffs' interest costs for 1981 through 1985. These re-assessments were confirmed by a judgment of the Tax Court of Canada in 1993.The plaintiffs bring these appeals from the Tax Court of Canada decision by way of a trial de novo.By order of this Court, the four appeals were heard simultaneously and on the basis of common evidence and argument.

7 The plaintiffs called four witnesses. Arnold Steinberg set out the corporate structure and objectives of Justinian and his own involvement as a shareholder and its sole Canadian director. Irving Ludmer explained the plaintiffs' reasons for and expectations in investing in Justinian. Professors Jacques Bourgeois and To Minh Chau testified as expert witnesses to compare the performance of Justinian with that of companies on the Toronto Stock Exchange 300 Composite Index (“TSE 300”). The plaintiffs also filed the evidence of a Revenue Canada official, John D. Rowe.The plaintiffs had intended to call the testimony of one other shareholder of Justinian and of Augustus. The plaintiffs chose not to proceed with these two witnesses.

8 The defendant called three departmental officials to testify concerning the investigation of the plaintiffs' investments and the tax deductibility of their interest payments, the intra-departmental consultation which ensued and the eventual issuance of the re-assessments.

9 The parties produced over 650 documents, mostly on consent.

The corporate organization and objectives of Justinian

10 For some thirty years, Arnold Steinberg was the chief financial officer and a member of the Board of Directors of Steinberg Inc., a retail food chain and shopping centre company. He held these positions until his family sold its interest in the company in 1989.

11 In the 1970's, Mr. Steinberg developed a business relationship with Ronald Meade, a partner in an investment company which owned Altamira Management Limited. Mr. Meade was a specialist in trading fixed income securities and, in Mr. Steinberg's view, the leading fixed income manager in Canada. Mr. Steinberg relied on Mr. Meade's advice for the Steinberg Inc. pension fund and for his family's private holdings.

12 In 1976, Mr. Meade informed Mr. Steinberg that, for personal reasons, he would be moving to the Bahamas. Mr. Meade agreed to continue to act as investment counsellor for Mr. Steinberg and other select clients.

13 It was on the occasion of Mr. Meade's move to the Bahamas that Justinian was created as the fixed income securities vehicle for the investments of Mr. Steinberg and its other shareholders. Mr. Meade introduced Mr. Steinberg to the late Bruce Verchère, a Montréal solicitor specializing in tax law. Mr. Verchère's advice set out the tax advantages in having an offshore investment company to hold these fixed income securities. This tax advice also coincided with a growing concern of some persons with the evolving political situation in Quebec in the 1970's and, more particularly, with the possible threat of foreign exchange controls. It was in this environment that Mr. Steinberg participated in the creation of and invested in Justinian. However, in Mr. Steinberg's words, there was not “the slightest doubt” in his mind that he would have continued his business relationship with Mr. Meade even without the tax benefits from offshore investments and the concern with foreign exchange controls. Mr. Steinberg's prime consideration was to continue to benefit from Mr. Meade's advice. He also understood the tax and other benefits that would flow from his investment counsellor's move to the Bahamas and his involvement in this offshore company.

14 The tax features of Justinian are described in documents, most of which were prepared by Mr. Verchère. These features are set out in the first of the documents prepared by Mr. Verchère in September 1976.The principal objectives were tax deferral and savings to be achieved principally by the re-investment of earnings and the redemption of shares upon disposition. Justinian would be incorporated in Panama and managed outside Canada and the United States so that its income and profits would not be taxed in those jurisdictions. Its directors would be principally non-residents.

15 In 1976, the Foreign Accrued Property Income (“FAPI”) tax rules took effect. These new provisions triggered annual taxation for residents of Canada who held shares in a non-Canadian corporation to the extent of its passive income, even if not distributed. Mr. Verchère recommended that the holdings of each investor in Justinian be limited to less than ten per cent of its shares to circumvent the impact of FAPI. In so doing, Justinian's income could accrue with taxes being deferred.

16 The other principal objective was to minimize taxes on the disposition of shares by Justinian's shareholders. In the words of Mr. Verchère, “[t]he preferable manner of repatriating the earnings of [Justinian] would be by a redemption of shares. In particular, the deemed dividend rules would not apply ... with the result that the accumulated investment income of [Justinian] would be subject to capital gains treatment.”

17 These tax features are summarized in a second planning document of January 1977:

• a) the Fund would not be subject to any Canadian income tax either with respect to interest income or gains on its sales of Fund assets;

• b) the Canadian shareholders would not be subject to any income tax with respect to their investment in the Fund except to the extent of dividends received or proceeds of disposition of their shares;

• c) proceeds of dispositions of the shares by the Canadian shareholders, whether by way of sale or redemption, would give rise to taxation as capital gains.

18 The revised version of the Confidential Explanatory Memorandum for Justinian dated August 15, 1977reflects, in my view, the principal tax features described in the earlier planning documents. The Description of Capital Stock sets out the restriction on the ownership by any person of class A shares to 9.9%. The sections concerning the Taxation of the Fund and the Taxation of Canadian Shareholders set out the criteria for sheltering Justinian, to the extent possible, from Canadian and Panamanian taxation. This would assure the circumvention of the FAPI rules and that gains realized upon disposition through redemption or sale of the shares would be subject to the capital gains tax regime.

The dividend policy of Justinian

19 Mr. Steinberg invested in Justinian and was its only Canadian director. He was involved in the decisions of the Board of Directors to declare dividends. From 1978, Justinian declared an annual dividend of US$1 for each year of its existence.

20 Justinian's Explanatory Memorandum set out its original Dividend Policy:

Initially, it will be a policy of the Fund to accumulate earnings for reinvestment. In the event that the Board of Directors of the Fund feel at any time that it is in the best interests of the Fund and its shareholders to declare and pay a dividend, payment will be made in United States dollars or any other currency selected by the Board of Directors of the Fund.

21 The wording of the Dividend Policy had changed slightly by 1978:

The Fund will accumulate the major portion of its earnings for reinvestment. However, in each year that the Fund has earnings it is anticipated that the Board of Directors of the Fund will declare and pay a dividend to shareholders of some portion of the Fund's earnings. Payment of dividends will be made in United States dollars or any other currency selected by the Board of Directors of the Fund.

22 By 1981, the Policy reflected Justinian's practice since 1977:

The Fund accumulates the major portion of its earnings for reinvestment. However, in the past, it has been the policy of the Board of Directors of the Fund to declare and pay a dividend to shareholders for years in which the Fund has earnings, and it is anticipated that the Board of Directors will continue to follow this policy. Payment of dividends will be made in Canadian dollars or any other currency selected by the Board of Directors of the Fund.

23 Mr. Steinberg described the implementation of Justinian's Dividend Policy as being no different than that of other public and private companies with which he had a similar involvement.The objectives of management were weighed against the differing interests among its shareholders. Justinian paid a dividend from the first year of its operations to distinguish itself from more speculative companies that issued no dividends and to establish communications with its shareholders. Mr. Meade's role was also a factor. In Mr. Steinberg's words, it was obvious that based on “...the historical investment performance of Mr. Meade, that it was unlikely that people getting those dividends would be able to improve upon it on their own, which is the reason that they put their money with him to start with, and yet to have no dividends whatsoever was inappropriate for the reasons I have mentioned.”There was no preset policy concerning the payment of dividends.The Board addressed the issue annually. As an investor, he had expected that, other things being equal, the dividend would increase relative to the earnings over time. He did not state that he expected the dividend yield to increase.By the early 1980's, the value of Justinian's shares had increased and the dividend payment remained at US$1 annually. Mr. Steinberg explained the Board's decision not to increase the dividend payment “when we moved into the '80's” as a measure to conserve earnings to counter the possible negative impact of the volatile interest rates in those years.

24 Mr. Steinberg's testimony concerning the Dividend Policy is, generally speaking, on all fours with the documentary evidence. His stated reasons for annual dividend payments are consistent with the Dividend Policy that the major portion of Justinian's earnings would be accumulated for reinvestment. In my view, the concern with the volatility of interest rates is more relevant for the dividend payments of 1981 and 1982, the years of Justinian's sharpest growth in asset value and when interest rates reached their highest levels. Its relevancy as a factor influencing the dividend payments in the other years is less apparent. The Dividend Policy, re-stated in October 1981 when interest rates were at their peak, referred to the company's past practice and added that “... it is anticipated that the Board of Directors will continue to follow this policy.”

25 As I understand this evidence, the US$1 payments reflected Justinian's Dividend Policy, the reliance on Mr. Meade's expertise for the reinvestment of earnings, the objective of deferring taxes until disposition of the shares by redemption and, for a period of time only, the concern for the volatility of interest rates. Justinian's objectives and, apparently, the Board's view of the interests of its shareholders remained constant. So did the dividend payments. The Explanatory Memorandum's stated objective concerning the capital gains treatment of accumulated earnings was consistent with the shareholders' interest in deferring tax payments. A higher dividend yield would run counter to both this objective and the shareholders' interest. In this sense, the Dividend Policy was constant or “preset”. It is not surprising, therefore, that the Board of Directors' annual implementation of the Dividend Policy resulted in a yearly dividend payment which remained unchanged.

The plaintiffs' objectives and expectations in Justinian

26 Irving Ludmer was the sole shareholder of the plaintiff Ludco Enterprises Limited until 1981 and the sole shareholder of its newly created parent company thereafter. He is the father of the plaintiffs Brian, David and Cindy Ludmer and acted on their behalf concerning their investments in Justinian.

27 After graduating from McGill University as an engineering physicist in 1957, Mr. Ludmer worked with Steinberg Inc. for fourteen years principally as head of the company's real estate division.In 1971, Mr. Ludmer left Steinberg to pursue real estate activities for his own account. In 1984, he returned to Steinberg Inc., for a short time in his previous capacity with its real estate division, before assuming the position of president and chief executive officer of Steinberg Inc. He remained in these positions until the sale of the company in 1989.

28 It was Arnold Steinberg who first introduced Irving Ludmer to the Justinian investment opportunity in 1977. It was only shortly prior to 1977, as the result of Mr. Ludmer's financial success in real estate, that the plaintiffs acquired sufficient liquid assets to consider making their investments in Justinian.At that time, Mr. Ludmer had no regular stockbroker.Mr. Ludmer's experience in real estate would have made him very familiar with leveraging of business opportunities and the deductibility of interest in real estate. The evidence is less clear that, as early as 1977, he had the same knowledge and familiarity in the financial markets as he had in real estate which, in his words, “... I knew a lot better.”The parties' admission that Mr. Ludmer acquired considerable knowledge and experience in financial markets throughout his career at Steinberg Inc.is of little assistance in assessing Mr. Ludmer's knowledge of financial markets in 1977.

29 Mr. Ludmer's decision to invest in Justinian was driven principally by Mr. Meade's previous performance. The tax advantagesand rumours concerning the possibility of foreign exchange controls were also factors. He sought no professional advice before deciding to invest.He saw none of the planning documents other than the Explanatory Memorandum and the letter setting out the performance record of the Altamira Income Fund between 1971 and 1976.Mr. Meade was one of the senior portfolio managers of this fixed income security fund. Mr. Ludmer did not know Mr. Meade, other than by reputation, when the plaintiffs made their first investments in Justinian in 1977.

30 Mr. Ludmer stated clearly that the plaintiffs would not have invested in Justinian with borrowed funds if he would have known that the interest costs were not deductible from income.He sought no advice concerning the tax deductibility of interest when the plaintiffs invested in Justinian with borrowed funds.Had he known the interest was not deductible, the plaintiffs' investments would have been limited to the extent to which they could have been financed with their equity. These responses by Mr. Ludmer confirm that interest deductibility was the principal additional factor for the leveraged portion of the plaintiffs' investments. There is no suggestion here that the plaintiffs' purpose was to earn dividend income.

31 Mr. Ludmer read and characterized as the “standard sort of verbiage” the Dividend Policy section of the Explanatory Memorandum.Based on Mr. Meade's track record with the Altamira Income Fund, Mr. Ludmer projected that Justinian would earn an annual return of 14% on its investments from which he thought reasonable to expect a 1% dividend yield for the first five years, 3% for the next three years and 4% thereafter.Mr. Ludmer's responses concerning his methodology at arriving at his “anticipated dividends” were not precise.No contemporary documents were produced. He denied any knowledge of Justinian having a preset or fixed dividend policy.In his view, his expectations were consistent with the company's written Dividend Policy.

32 It was imprudent, in my view, for Mr. Ludmer to read the Dividend Policy as “standard verbiage”. There is no evidence to show that the Dividend Policy was in boilerplate language. The reader was alerted that the major portion of the earnings of this offshore company investing in fixed income securities would be reinvested. While there is little evidence on this point, a potential investor may well have expected, absent the Dividend Policy and the tax and other considerations particular to Justinian, that the major portion of the gains from fixed income securities would be distributed to the shareholders annually. I am comforted in this view by the substantially different dividend policy in the 1986 Offering Circular of the Altamira Preferred Dividend Fund where dividends would be paid monthly in an amount equal to one-twelfth of the fund's estimated annual income:

...dividends will be paid on or before the last day of each month ... in amounts estimated by the Manager to equal one-twelfth of the estimated annual net income of the Offeror for income tax purposes for the calendar year. The amount of dividends paid from time to time will be adjusted by the Offeror to take account of changes in the yield on its portfolio investments, to provide adequate reserves for taxes, the Manager's fees and other liabilities and to provide for contingencies and other matters. The Offeror may also pay such other dividends at such times as its board of directors may determine in its sole discretion.

33 In October 1977, the Ludmer children acquired a total of 10,000 shares of Justinian at US$100 per share. In July 1978, they doubled their holdings. The total acquisition cost of their investments was $2.2M. In July and December 1978, Ludco Enterprises Ltd. invested a total of $2.3M in Augustus. Approximately eighty per cent of these four investments were financed with funds borrowed from Canadian chartered banks in different loans at floating rates of prime plus 1% or3/4%. The carrying cost of the plaintiffs' loans increased from about 10% in late 1977, through 14% in 1979 to a peak of 20% in early 1981 before stabilizing at approximately 12% in 1983 until the disposition of their shares in 1985.In the fifth of the plaintiffs' transactions, in June 1979 Ludco invested $3M in Justinian. All the funds for this acquisition were borrowed through a long-term mortgage on a Ludco shopping centre property with a fixed interest rate of 11.5%.

34 In December 1980, the plaintiff Ludco Entreprises Ltd. sought to acquire an additional 10,000 shares in Augustus for a value of $1.4M. This acquisition was to be fully leveraged with a loan from a Canadian chartered bank, initially bearing interest at 19% per year or3/4% over the bank's best lending rate. Ludco's application for these shares was refused, presumably because its holdings would have been in excess of the 9.9% threshold required to circumvent the FAPI rules.Despite a dividend yield of less than 1% for 1978, 1979 and 1980,Mr. Ludmer was interested in acquiring additional shares because the high interest rates presented “an unusual opportunity”for Mr. Meade to use his skills in the cyclical management of fixed income securities in an environment of volatile interest rates. For Mr. Ludmer, governments could not tolerate interest levels at 18% to 20% in the long term. This provided Justinian with an opportunity to “really make money on bonds”,and to “make a killing”.Mr. Ludmer never suggested that Justinian's monthly reports on its investment activities held out hope that such a strategy was being contemplated.Before the Tax Court of Canada, Mr. Ludmer acknowledged that one of the reasons for this attempted investment in 1980 was to minimize the tax payable by Ludco through the deducibility of its interest expense.

35 There is no evidence to suggest that Justinian's investment strategy was to change in December 1980 or shortly thereafter from the conservative policy implemented since its inception. From this, and on the basis of Mr. Ludmer's response in the Tax Court of Canada, I conclude that his reasons for wanting Ludco to make a fully leveraged investment of $1.4M in December 1980, when interest rates were at 19%, were substantially the same as those in 1977 when the cost of money was significantly less: Mr. Meade's track record, the tax savings provided for in the Explanatory Memorandum and Mr. Ludmer's assumption of interest deductibility. The relevance of one's concern for foreign exchange controls is even less apparent with a fully leveraged investment in a company whose assets were still substantially in Canadian denominated securities.

36 The plaintiffs did not dispose of their shares in Justinian until 1985 when the FAPI rules were amended to prevent their circumvention through vehicles such as Justinian.

37 Although Mr. Ludmer's expected dividend yields were not met, he testified that Justinian's actual returns were very close to his own projections of 14% on an annual basis.

Revenue Canada's investigation, the FAPI amendments and the re-assessments

38 The Defendant's evidence was substantially documentary. The documents were spoken to by three officials.

39 The initial examination concerning the offshore funds was made by Herbert Gutenplan, an auditor in the Montréal district office of Revenue Canada. Mr. Gutenplan investigated Justinian and other similar offshore companies in 1980-81. His direct involvement in this investigation appears to have ended some months after he submitted his report of June 23, 1981 to the Specialized Audit Division in Ottawa.On the basis of the evidence available to him, he concluded that Justinian did not carry on its business in Canada and could not be taxed in this jurisdiction. He characterized the annual dividend of US$1 per share as “nominal”. In an earlier report, he described the dividend as “very low”. He reached this view after comparing the dividend payments with the shareholder's interest costs, the total earnings per share available for distribution and the costs of investment or the fund's asset value per share.Mr. Gutenplan acknowledged that he knew of no departmental guidelines concerning the “nominality” of dividends. He also noted that earnings flow to the investor in the form of capital gains on the redemption of shares and accordingly taxable as such. Finally, he advised in his report that interest paid on loans to finance the investment in the Justinian-type of company was used by taxpayers to reduce income from other sources. On the basis of these observations, Mr. Gutenplan recommended that “investors claiming interest expense on these investments be re-assessed” by limiting their interest expense to income received from the fund.

40 Mr. Gutenplan's report generated a debate among Revenue Canada officials. There was a division of opinion concerning interest deductibility and the recommended re-assessments. One official clearly disagreed with Mr. Gutenplan and felt any proposed re-assessment limiting interest deductibility to the extent of Justinian dividends could not be upheld if challenged.

41 In his budget of November 12, 1981, the Minister of Finance proposed that the deduction of interest as an expense in the taxation year be restricted to the amount of income produced from the investment in that year. This proposal was analogous to Mr. Gutenplan's recommendation but was not adopted by Parliament and was abandoned.

42 In March 1983, a subsequent position paper concluded that the interest deductibility could be disallowed since the interest payments were not made to earn income and would, if allowed, unduly or artificially reduce income. This paper did not indicate whether all, or only the portion of the interest payments equal to the dividend income, would be deductible.

43 In November 1983, the Director, Tax Avoidance of Revenue Canada addressed the annual meeting of the Canadian Tax Foundation and stated that “[t]he interest deduction, to the extent that it exceeds the nominal dividends received, will be rejected pursuant to subsection 9(3) and paragraph 20(1)(c).”

44 Richard Biscaro, a senior tax avoidance officer, undertook an independent review of the information marshalled by Mr. Gutenplan. His concern was twofold: the funds were designed to circumvent the FAPI rules and the deductibility of interest where the dividends were, in his words, “small”.In late December 1983, as part of his independent review, Mr. Biscaro reported that: “Interest on funds borrowed to invest in shares of offshore investment companies should be disallowed pursuant to sections 9(3) and 20(1)(c). The intention of the investors is to earn capital gains rather than income from property.”

45 By June 1984, departmental policy was formalized. Mr. Biscaro's proposal was accepted. Interest on funds borrowed to invest in shares of offshore investment companies was to be disallowed pursuant to subsection 9(3) and paragraph 20(1)(c) in view of the policy of funds such as Justinian to pay “nominal” dividends and the intention of the investors to earn capital gains rather than income from property.Prior to proceeding with re-assessments in accordance with this policy, a compromise position would be offered to the taxpayer.

46 In February 1985, in the implementation of this departmental policy, Mr. Franco Tirabasso of the Montréal office of Revenue Canada re-activated the plaintiffs' files. This review resulted in the issuance of the re-assessments and this litigation. According to the departmental policy, an offer of settlement was made to the plaintiffs in April 1985. The terms of the offer of settlement were stated as follows:

In the past there may have been differences of opinion between shareholders of investment corporations and Revenue Canada, Taxation as to the correct treatment of the interest expense. Recognizing this fact and in order to resolve the issue in an equitable manner for both the Canadian investor and ourselves, we are prepared to offer the following settlement to those shareholders who have claimed an interest expense deductions (sic):

• 1. In 1982, the increases in the value of the investment in investment corporations from the date of purchase to December 31, 1981 will be declared and reported as a capital gain for Canadian tax purposes. In addition, the increase in value for the period January 1 to December 31, 1982 will be declared and reported as an income gain.

• 2. In 1983, the increase in the value of the investment for the year will be declared and reported as an income gain.

• 3. In 1984, the increase in the value of the investment for the year will be declared and reported as an income gain.

• 4. Provided that the interest is paid or payable (depending upon the method regularly followed by the Canadian taxpayer in computing his income) pursuant to a legal obligation to pay interest, and provided the amount of interest is reasonable in the circumstances, the interest expense will be allowed in the year paid or payable.

For those Canadian investors who accept the above offer a letter of undertaking suitable to both parties will have to be filed with Revenue Canada, Taxation.

47 There was less departmental controversy, if any at all, concerning Justinian's circumvention of the FAPI rules. Legislation would be required to prevent taxpayers from deferring taxes on passive income on offshore companies by limiting their interest to less than 10% of the shares. This could not be achieved through re-assessments. In his budget of February 15, 1984, the Minister of Finance announced an amendment to prevent the avoidance or undue deferral of income tax through the use of offshore funds. This amendment effectively brought Justinian's and other similar funds to an end.

48 The defendant's witnesses were extensively cross-examined on departmental position papers, information sheets (“hot line questions” or “green line questions”) and policy statements, all of which suggested, in the view of the plaintiffs, some merit in their position on interest deductibility. Some of this information was only relevant by way of analogy to other factual situations. In any event, none of this information even if it had been uniform and uncontradicted, is either determinative of the issues or binding on this Court.

Did the plaintiffs have a reasonable expectation that the dividends would eventually exceed their interest expense?

49 Jacques Bourgeois and To Minh Chau are professors of finance at the Hautes études commerciales in Montréal. Neither purports to be an expert in taxation. Both contributed to the preparation of the report which was signed by Professor Bourgeois. The defendant did not object to their giving opinion evidence as experts concerning their report.

50 The report first compares the performance of a $100,000 investment on the basis of the TSE 300 composite index, fully leveraged with a loan at 1% over prime, between 1978 and 1995. Dividends are re-invested and interest paid annually. With the added assumption of interest deductibility, cumulative gains are realized in each year. With no interest deductibility, there are still annual gains except for 1990 through 1992.

51 The report then concludes that Justinian's annual dividend of US$1 between 1978 and 1985 was within the norm of dividend yields for common shares of new companies with similar risks which were listed on the Montréal or Toronto Stock Exchanges. Finally, the report notes that the interest rates paid by the plaintiffs for their loans were appropriate and that Mr. Ludmer's expected rates of return were generally realized.

52 During 1978 through 1985, the plaintiffs' interest costs were greater than the income they received from Justinian in each year. However, the annual expected dividends would have been in excess of the interest costs by 1985, some seven years after the original investment, if Mr. Ludmer's expected dividend yields and his projected rate of growth in Justinian's share value had been realized.This did not occur. Justinian's annual dividend never increased and its asset value grew at a rate less than Mr. Ludmer's expectations, at least over the first seven years.

53 Even if Mr. Ludmer's assumptions had been fully realized, 1985 was only the cross-over year. The accumulated losses from interest expenses exceeding dividends prior to 1985 would only be recovered over an unspecified number of subsequent years and, again, only if the plaintiffs did not dispose of their shares.

54 Even if Mr. Ludmer had the foresight in 1977 to predict in the prevailing economic conditions that this cross-over between dividends and interest expense would eventually occur, there is no evidence that his original intention was to hold on to these shares through and even beyond 1985. It would not be realistic for an average investor to have formed such a certain intention and Mr. Ludmer never so suggested in his testimony. In fact, he acknowledged that he had considered the disposition of the shares prior to 1985.

55 The evidence concerning the plaintiffs' expectations becomes even more speculative and less relevant with the plaintiff Ludco Enterprises Ltd. prepared to make a fully leveraged investment of $1.4M in December 1980, when interest rates were double those of 1977. Even if Mr. Meade “really made a killing” by taking advantage, according to Mr. Ludmer, of the high interest rates which would of necessity decrease, there is no evidence to suggest that the dividend payments, let alone the dividend yield, would have increased substantially, if at all, on the assumption of these windfall profits. Justinian's principal objectives of tax deferral and tax savings were to be achieved principally through the reinvestment of the major portion of its earnings and the redemption of shares upon disposition, not through dividend payments. This is clear from the planning documents. It is further confirmed by Mr. Steinberg's evidence that Justinian's investors could not improve upon Mr. Meade's own performance in the investment of Justinian's earnings.

56 The Court has two fundamental concerns with the evidence of Professors Bourgeois and To and the extent to which it can usefully be relied upon in Mr. Ludmer's testimony.

57 First of all, the exercise of comparing Justinian with the TSE 300 invites serious scrutiny. Justinian was not a Canadian company. It was not a corporation taxable in Canada or elsewhere. Because its shareholders could not exceed fifty, it was not subject to Canadian securities legislation. Its shareholders were limited to less than 10% of its shares to avoid the FAPI rules. Minimum subscription was US$100,000. It had no physical plants and very few employees. Its assets were limited to securities. Its income was passive. Its shares were redeemable on demand of the shareholders. There is no evidence that any shareholder traded Justinian shares to another person. Justinian's lifespan ceased after eight years. Its creation was for tax purposes. Its demise was the result of legislation amending the FAPI rules. In short, it was a company substantially different from virtually all, if not all, the TSE 300 companies.

58 The other concern is at least of equal importance. Professor Bourgeois confirmed the reasonableness of Mr. Ludmer's expected dividend yields of 1%, 3% and 4% during the first years of Justinian.He noted that the TSE 300 had a 3.96% average dividend yield during the same period. Yet, in the report's principal substantive conclusions, he states that Justinian's annual dividend payment of US$1 was consistent with the dividend policy of other similar companies and of 77% of the companies currently traded on the Montréal and Toronto stock exchanges which either pay no dividend at all or at a dividend yield of less than 1%.

59 It is not significant, in my opinion, to suggest that Mr. Ludmer's expected dividend yields were reasonable and compared favourably with the TSE 300 average yield and that Justinian's dividend payments were within the norm of 77% of publicly traded companies. In both instances, the comparison is between apples and oranges. The two comparisons combined are meaningless. Mr. Ludmer's expected yields were to increase after 1% for the first five years when in fact Justinian's dividend yield was always lower than 1% and decreasing. The gap between expected and actual yields was growing. Either Mr. Ludmer's expectations were too high or Justinian's dividends were too low. The former cannot have been reasonable and the latter within the norm.

60 After reviewing closely Professor Bourgeois' testimony and his report, I have concluded that his comparison of the plaintiffs' investments in Justinian with a similar investment in a TSE 300 company is not relevant. In my opinion, the plaintiffs' expert evidence is of little, if any, use in the resolution of the issues in this case.

61 In summary, I accept that in 1977 the plaintiffs had a reasonable expectation of receiving dividends in accordance with the Dividend Policy. The expectation that the dividends could increase over time relative to the earnings, as mentioned by Mr. Steinberg, in no way suggests an increase in the initial dividend yield of slightly less than 1%.There is no relevant evidence to support the plaintiffs' 1977 stated expectation that the dividend yield would triple after five years, quadruple after eight years or even increase significantly at any time. There is no evidence that the dividend yield would ever approach the interest rates of 10% in 1977, let alone the higher rates in subsequent years. Nor is there evidence that in 1977 the plaintiffs could expect a material decrease in interest rates in the near term. The plaintiffs' purpose in borrowing funds at the prevailing rates in 1977 and subsequently, was not to earn a dividend yield of 1% or, in the language of sub-paragraph 20(1)(c)(i), for the purpose of earning income from a business or property.

62 The comparison with the TSE 300 does not take into account Justinian's Dividend Policy, which was more than standard verbiage, and Justinian's objective of accumulating its earnings to defer the payment of taxes for its shareholders. This comparison is not relevant to justify Mr. Ludmer's expected dividend yields as the basis for the plaintiffs' reasonable expectation of profit.

63 Before the Tax Court of Canada, Mr. Ludmer acknowledged that he did not expect “...that the dividends would cover my interest expense and in any investment that I have made in real estate or stocks, subsequent, I never expected that either.”In explaining why people borrow to invest in the stock market, he added that “... the combination of the dividends together with the gains on disposition made up more, hopefully, than the cost of money...”.During the period in question, he was not aware of any shares in Canada which yielded dividends equal to the prevailing interest rates.On the basis of all the evidence, I have chosen to accept Mr. Ludmer's testimony before the Tax Court of Canada that he did not expect the dividends to cover the interest expense over any contrary suggestion made during this de novo appeal.

64 In fact, Justinian's dividend yield decreased continually. The spread between expected and actual yields constantly grew. There is no evidence that Mr. Ludmer expressed any concern to Justinian's Board of Directors, Mr. Steinberg, Mr. Meade, who did not testify, or anyone else. Yet, the plaintiffs were ready to make further acquisitions in July 1978, December 1978 and December 1980 while the cost of their loans at floating rates increased to 12%, 14% and 19% and to continue to keep their investments through 1981 when interest rates peaked at over 20%. The plaintiffs' ongoing interest to acquire and to continue to hold Justinian shares throughout this period satisfies me, beyond a balance of probabilities, that they had no expectation of profit, reasonable or otherwise, in the sense that they never expected, in 1977 or subsequently, that the dividends would exceed their interest expense.

65 The profits in their investment would be realized upon disposition. Indeed, this is the way Justinian was structured. The plaintiffs' disposition of their shares in 1985 by exercising their right of redemption resulted in profits which, as set out in the Explanatory Memorandum, would be subject to the capital gains tax regime.

The legal principles concerning interest deductibility

66 The most authoritative interpretation of paragraph 20(1)(c) is the Supreme Court of Canada decision in Bronfman Trust v. R., [1987] 1 S.C.R. 32 (S.C.C.). After noting that interest payments would not be deductible from income in the absence of this statutory provision, Chief Justice Dickson went on to write at pages 45-6:

Parliament created s. 20(1)(c)(i), and made it operate notwithstanding s. 18(1)(b), in order to encourage the accumulation of capital which would produce taxable income. Not all borrowing expenses are deductible. Interest on borrowed money used to produce tax exempt income is not deducible. Interest on borrowed money used to buy life insurance policies is not deductible. Interest on borrowings used for non-income earning purposes, such as personal consumption or the making of capital gains is similarly not deductible. The statutory deduction thus requires a characterization of the use of borrowed money as between the eligible use of earning non-exempt income from a business or property and a variety of possible ineligible uses. The onus is on the taxpayer to trace the borrowed funds to an identifiable use which triggers the deduction. Therefore, if the taxpayer commingles funds used for a variety of purposes only some of which are eligible he or she may be unable to claim the deduction.

The interest deduction provision requires not only a characterization of the use of borrowed funds, but also a characterization of “purpose”. Eligibility for the deduction is contingent on the use of borrowed money for the purpose of earning income. It is well-established in the jurisprudence, however, that it is not the purpose of the borrowing itself which is relevant. What is relevant rather, is the taxpayer's purpose inusingthe borrowed money in a particular manner.

[The italics are added.]

1 In Moldowan v. R. (1977), [1978] 1 S.C.R. 480 (S.C.C.), Justice Dickson, as he then was, spoke of “source of income” and “reasonable expectation of profit” (at pages 485-6):

Although originally disputed, it is now accepted that in order to have a “source of income” the taxpayer must have a profit or a reasonable expectation of profit....

There is a vast case literature on what reasonable expectation of profit means and it is by no means entirely consistent. In my view, whether a taxpayer has a reasonable expectation of profit is an objective determination to be made from all of the facts. The following criteria should be considered: the profit and loss experience in past years, the taxpayer's training, the taxpayer's intended course of action, the capability of the venture as capitalized to show a profit after charging capital cost allowance. The list is not intended to be exhaustive.

First, it was decided in Moldowan that in order to have a source of income a taxpayer must have a reasonable expectation of profit. Second, “whether a taxpayer has a reasonable expectation of profit is an objective determination to be made from all of the facts” (supra at 485-86). If as a matter of fact a taxpayer is found not to have a reasonable expectation of profit then there is no source of income and, therefore, no basis upon which the taxpayer is able to calculate a rental loss.

2 In this case, as in Mark Resources Inc. v. R. (1993), 93 D.T.C. 1004 (T.C.C.)at 1012, the earning of dividend income cannot be said to be the real purpose of the use of the borrowed funds. Justinian's dividend payments were “subservient and incidental steps to the real objective that lay behind the implementation” of its policy to accumulate and reinvest earnings which, upon disposition of the shares through redemption, would be taxed as capital gains.

3 The recent decision of the Supreme Court of Canada in Hickman Motors Ltd. v. R., [1997] 2 S.C.R. 336 (S.C.C.), and the obiter dicta in Mark Resources Inc., supra, at 1013-15 do not find their application, in my view, to the facts of this case, and more particularly, to the true purpose of the plaintiffs' investments in Justinian in the context of the object and spirit of the Income Tax Act as a whole.

4 The application of these principles to this litigation is straightforward. On the evidence in this case, the borrowed funds were not used for the purpose of earning income within the meaning of sub-paragraph 20(1)(c)(i). The dividends were neither profit nor could they be the basis of a reasonable expectation of profit in 1977, when the plaintiffs' interest cost was 10%, or at any time thereafter. As Mr. Ludmer succinctly stated, the plaintiffs did not borrow money to lose money. They made their money, however, upon the disposition of their shares. Their profits, which they expected and realized, are capital gains, not income. This is the very outcome foreseen in Justinian's Explanatory Memorandum.

5 The plaintiffs' other submission can be dealt with as summarily as it was presented. Not all investments aimed at capital gains constitute an adventure in the nature of trade. In this case, the plaintiffs disposed of their shares through redemption. Shareholders had the right to have their shares redeemed by Justinian. In applying for the shares, the plaintiffs represented that their acquisitions were for the purposes of investment. The plaintiffs were not carrying on a business engaged in an adventure or concern in the nature of trade with these investments.

6 In view of my disposition of the principal issues, it is not necessary to deal with the parties' submissions concerning artificial transactions and section 245.

7 For these reasons, the appeals are dismissed with costs to the defendant in one of the four actions.