Leduc v. The Queen, docket 1999-1658-IT-I (Informal Procedure)

Date: 20001101

Docket: 1999-1658-IT-I

BETWEEN:

HUGUETTE LEDUC,

Appellant,

and

HER MAJESTY THE QUEEN,

Respondent.

Reasonsfor Judgment

Lamarre Proulx, J.T.C.C.

[1]            This is an appeal under the informal procedure respecting the 1992 to 1996 taxation years.

[2]            The issue concerns the deduction of interest paid on a loan taken out to build a house from the interest received on the balance of the sale price of that house. It involves the application of subparagraph 20(1)(c)(i) of the Income Tax Act (the "Act").

[3]            The facts on which the Minister of National Revenue (the "Minister") relied in making the reassessments are set out in paragraph 7 of the Reply to the Notice of Appeal (the "Reply") as follows:

[TRANSLATION]

(a)            in 1988, the appellant and her husband financed the construction of a house at 147 rue de l'Équerre in Ste-Rose (the "Property") by means of a $75,000 personal line of credit from the National Bank and a $60,000 loan from Réal Pelletier;

(b)            on May 4, 1990, the appellant became the sole owner of the Property;

(c)            on August 16, 1991, the appellant sold the Property for $140,000;

(d)            the appellant financed the purchaser of the Property to the extent of $120,000 at an interest rate of 9% for the first five years and 10% for the following five years;

(e)            the appellant paid in interest expenses for the 1992, 1993, 1994 and 1995 taxation years the amounts set out in Schedule A attached hereto; and

(f)             for the 1992, 1993, 1994, 1995 and 1996 taxation years, the appellant did not pay interest amounts in excess of those allowed by the Minister in relation to her income from property.

[4]            The grounds of appeal set out in the Notice of Appeal are as follows:

[TRANSLATION]

The amounts indicated on the Notice of Confirmation—$4,800 in 1992, $4,800 in 1993, $4,800 in 1994, $4,800 in 1995 and $7,370.95 in 1996—were indeed the interest paid on a $60,000 loan which was used for the construction of the property situated at 147 de l'Équerre, Laval, Quebec. Therefore, I have no choice but to object in order not to have to pay tax on the interest that I paid.

At the hearing of the appeal, I will provide you with the bank statements from the National Bank for 1988, which show a deposit of $30,000 on May 13, 1988, and another of the same amount on June 17, 1988, for the construction, and which show as well the amounts of the cheques for payment of the invoices relating to this construction. In addition, I can provide you with the other statements for 1989, 1990 and 1991, which show the amount of interest paid on the $60,000 loan.

[5]            The Notice of Appeal was in response to the Notice of Confirmation which was attached to the Notice of Appeal and which gave the following reasons for the confirmation:

[TRANSLATION]

The amounts of $4,800 in 1992, $4,800 in 1993, $4,800 in 1994, $4,800 in 1995 and $7,370.95 in 1996 in respect of which you claimed a deduction from income were not interest on a loan used to earn income from a business or property as required by subparagraph 20(1)(c)(i). Accordingly, you may not claim a deduction under paragraph 20(1)(c).

[6]            The appellant himself and André Pelletier testified for the appellant. Réal Pelletier and Marius Patras testified for the respondent.

[7]            The appellant admitted subparagraphs 7(a) to 7(d) of the Reply.

[8]            Schedule A, referred to in subparagraph 7(e) of the Reply, indicates total interest income and the total amounts allowed as interest expenses. The amounts allowed are the interest paid to the National Bank of Canada (the "NBC"). The interest paid to Réal Pelletier in respect of the $60,000 loan was not allowed. The appellant therefore objects to subparagraph 7(e) of the Reply.

[9]            Exhibit I-2 consists of the appellant's income tax returns for the 1992 to 1996 taxation years. It also contains some work sheets and correspondence. On March 25, 1997, a letter was sent to the appellant by Revenue Canada informing her that in an audit it had been determined that her income had been understated by the amount of the interest received on the balance of the selling price. The amounts shown in Schedule A are $11,250, $11,250, $10,900 and $10,350 for 1992, 1993, 1994 and 1995 respectively.

[10]          An auditor's report (T-2020) contained in Exhibit I-2 states that, in a March 10, 1997, telephone conversation with André Pelletier, the appellant's husband, the auditor was told that the appellant received interest every month but immediately paid out an equivalent amount to pay back the $75,000 line of credit from the NBC and the $60,000 loan from Réal Pelletier.

[11]          The same report stated that, on April 22, 1997, there was a visit from the taxpayer and her accountant. The latter calculated only the amounts paid by his client to the NBC. The appellant signified her agreement by signing a document which was produced as Exhibit I-4.

[12]          The appellant testified that the accountant who had prepared this agreement was also the accountant of her brother-in-law,Réal Pelletier. As we shall see later, Réal Pelletier did not declare the interest income from the loans. The appellant maintains that she did in fact pay the interest and that is why she changed accountants.

[13]          Exhibit A-1 is an acknowledgment of a debt owed to Réal Pelletier, dated June 6, 1988. It is signed by the appellant and by A. Pelletier and reads as follows:

[TRANSLATION]

June 6, 1988

I hereby acknowledge that I owe to Réal Pelletier the sum of $60,000.

This sum was lent for the construction of the residence at 147 de l'Équerre, Ste-Rose, Laval.

Interest on the loan will be at the rate of 8% annually payable on each anniversary date.

The loan is a demand loan.

. . .

[14]          The appellant explained that she and her husband had given this document to Réal Pelletier. He returned it to them when the debt was paid in full. The signature of Réal Pelletier does not appear anywhere on the document.

[15]          The appellant produced as Exhibit A-2 a judgment of the Superior Court dated May 4, 1990, pronouncing the spouses separated from bed and board and giving effect to the terms of the collateral agreement in respect of the de facto separation and marriage breakdown, which agreement was signed by the parties thereto on February 12, 1990. The clause in the agreement concerning the ownership of the property and the responsibility of each spouse regarding the debts reads as follows:

[TRANSLATION]

4-              Each spouse shall be solely liable for all debts incurred by him or her. If one of the spouses assumes responsibility for all or part of a debt incurred by the other, the latter shall indemnify the former within thirty days and shall repay in full any liabilities thus assumed.

[16]          The house was sold in August 1991. The contract of sale was filed as Exhibit A-3.

[17]          Exhibit A-4 consists of six cheques. The words [TRANSLATION] "int on loan 147 de l'Équerre" appearing on these cheques were added after they were cashed by Réal Pelletier, according to his testimony. The first cheque is dated April 19, 1992. It is signed by the appellant. On May 7, 1993, another cheque, this one signed by André Pelletier, was drawn on the same account. According to the appellant, this was a joint account. The appellant said that she saw nothing strange about maintaining a joint account even though the two spouses were separated and supposed to have each assumed responsibility for their own debts. The cheque dated April 3, 1994, is signed by the appellant and that dated May 14, 1995, is signed by André Pelletier, as is the cheque dated May 13, 1996. These cheques are all in the amount of $4,800. The cheque dated November 26, 1996, is signed by the appellant. It is for $62,570.95.

[18]          During Réal Pelletier's testimony, a fax sent by him to Marius Patras on February 12, 1999, was filed as Exhibit I-1. That fax reads as follows:

[TRANSLATION]

. . .

For the attention of Marius Patras from Réal Pelletier. This is to confirm that I never lent money to Huguette Leduc-Pelletier and that there was no interest on the money that I lent to my brother, André Pelletier. The cheques he made out to me were for principal. There were loans of $2,000, $3,000 and $5,000 in cash, plus loans of $20,000, $10,000, and so on.

Réal Pelletier

My brother is two-faced; he is supposedly separated but they are still living together.

[19]          The witness said that he did not remember writing this and that it is not true. He said several times that he often lent money to his brother without charging interest. Subsequently, he said that he had just settled with Revenue Canada with respect to interest that he had collected but not declared. He paid the federal government $263,000. He is waiting to find out how much the penalties will be. After that, Revenu Quebec is going to assess him. He expects that altogether it will cost him $492,000. He said he lent $60,000 to the appellant and her spouse in two instalments of $30,000 each.

[20]          The report of Mr. Patras, inspecting auditor, was filed as Exhibit I-5. According to that report, this is what Réal Pelletier told him on November 19, 1998, concerning the repayment of the loan to his brother:

                [TRANSLATION]

·          He never lent money to Huguette Leduc.

·          His brother, André Pelletier, is approximately 50 years old and has been borrowing money from him since he was eighteen.

·          Réal Pelletier lent money to his brother in amounts of $15,000 or $20,000.

·          He remembers having lent money to his brother for the purchase of a house, for the construction of a cottage and for a restaurant on the outskirts of Mont-Laurier. But he never lent $60,000 at one time.

·          In fact, his brother still owes him approximately $18,000.

·          His brother and the taxpayer are not separated!!! They are living together at Lac Nominingue!!! They say they are separated in order to save on tax and to take advantage of other benefits!!!

·          Réal Pelletier is prepared to appear in court if witnesses are needed!!!

[21]          According to Mr. Patras, neither the appellant nor her accountant proved that the $60,000 in question was used to build the house. The lender spoke only of a cottage or a restaurant. The first accountant did not raise the point that other interest could be deducted. It was the second accountant who did so.

[22]          Exhibit A-5 consists of two bank statements for the periods ending on June 10, 1988, and on July 12, 1988, for an account André Pelletier had with the NBC. The first statement shows a deposit of $30,500 on May 13, 1988. On the second, there is a deposit of $30,000 made on June 17, 1988. Other amounts are also indicated. André Pelletier said that these amounts were expenses incurred in the construction of the house. He did not discuss these documents with Mr. Patras because Mr. Patras had not asked him to produce them.

Analysis

[23]          It was hard to understand the point in issue in this case. If one goes by the Reply, the issue seems to be whether the interest was really paid. The agent for the respondent said that the main point in issue was whether the interest paid on the loan was deductible under subparagraph 20(1)(c)(i) of the Act. According to her, it was not borrowed money used to earn income from property as required by subparagraph 20(1)(c)(i) of the Act. The deduction of the payments to the bank was allowed, but that was an error on the part of Revenue Canada because, she said, those payments are not deductible under that subparagraph. The agent for the respondent also wondered whether the $60,000 loan was in fact taken out for the construction of the spouses' principal residence. She did not deal with the fact that the interest payments were made from a joint account.

[24]          I understand from the testimony of the Minister's auditor that, if he had been convinced that the $60,000 loan had been for the construction of the house and that the interest had really been paid, he would have allowed that interest, just as the interest on the bank loan was allowed. The Minister's auditor said that the appellant never mentioned the interest on the $60,000. Actually, it was mentioned as early as October 1997. Subsequently, the appellant signed the document referred to in paragraph [11] of these reasons. However, she explained that she did so on the advice of the first accountant who was also her brother-in-law Réal Pelletier's accountant. She hired another accountant who did report the payment of the interest in question. With respect to the use of the $60,000 for the construction of the house, I see nothing specific on this in the auditors' reports. But as I have already said, it is admitted in subparagraph 7(a) of the Reply that the $60,000 loan was for the construction of the house. That must therefore be the starting point. In addition, I am of the view that the cheques produced together as Exhibit A-4 confirm the appellant's claims that they were for interest at 8 percent on a $60,000 loan.

[25]          The agent for the respondent referred to the decision of the Supreme Court of Canada in Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32, at page 46:

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 that is relevant. What is relevant, rather, is the taxpayer's purpose in using the borrowed money in a particular manner: Auld v. Minister of National Revenue, 62 D.T.C. 27 (T.A.B.) Consequently, the focus of the inquiry must be centered on the use to which the taxpayer put the borrowed funds.

Accordingly, she argued that the money was used for the construction of a principal residence and not to earn income.

[26]          Counsel for the appellant submitted that it was not a case of borrowed money used for purposes other than to earn income. He gave as an example the case of a person who borrows money to purchase a personal residence and several years later turns the residence into a restaurant or an inn. He does not understand why the interest would not be deductible in that case.

[27]          I also refer to the judgment of the Supreme Court of Canada inBronfman Trust (supra) at pages 47 and 48, in which there is an analysis of the original and current use of the funds borrowed and of their direct and indirect use. I cite several passages:

Original or Current Use of Borrowed Money

The cases are consistent with the proposition that it is the current use rather than the original use of borrowed funds by the taxpayer which is relevant in assessing deductibility of interest payments . . . . A taxpayer cannot continue to deduct interest payments merely because the original use of borrowed money was to purchase income-bearing assets, after he or she has sold those assets and put the proceeds of sale to an ineligible use. . . .

Conversely, a taxpayer who uses or intends to use borrowed money for an ineligible purpose, but later uses the funds to earn non-exempt income from a business or property, ought not to be deprived of the deduction for the current, eligible use . . . For example, if a taxpayer borrows to buy personal property which he or she subsequently sells, the interest payments will become prospectively deductible if the proceeds of sale are used to purchase eligible income-earning property.

There is, however, an important natural limitation on this principle. The borrowed funds must still be in the hands of the taxpayer, as traced through the proceeds of disposition of the preceding ineligible use, if the taxpayer is to claim the deduction on the basis of a current eligible use. Where the taxpayer has expended the borrowings on an ineligible use, and has received no enduring benefit or saleable property in return, the borrowed money can obviously not be available to the taxpayer for a subsequent use, whether eligible or ineligible. A continuing obligation to make interest payments to the creditor therefore does not conclusively demonstrate that the borrowed money has a continuing use for the taxpayer.

. . .

Direct and Indirect Uses of Borrowed Money

As I have indicated, the respondent Trust submits that the borrowed funds permitted the Trust to retain income-earning properties which it otherwise would have sold in order to make the capital allocations to the beneficiary. Such a use of borrowings, it argues, is sufficient in law to entitle it to the interest deduction. In short, the Court is asked to characterize the transaction on the basis of a purported indirect use of borrowed money to earn income rather than on the basis of a direct use of funds that was counter-productive to the Trust's income-earning capacity.

In my view, neither the Income Tax Act nor the weight of judicial authority permits the courts to ignore the direct use to which a taxpayer puts borrowed money. . . .

[28]          My understanding of the Bronfman decision is that, if a person borrows money for purposes that are not for earning income in circumstances where the person does not want to use the money to earn income, the interest on that loan is not deductible. The direct use of the loan in that case is not for the purpose of earning income. If a person borrowed money to purchase various assets from which the person earned no income, obviously, that person may not deduct the interest. However, if one of those assets is subsequently turned into income-earning property, the interest on the part of the loan used to purchase that property may be deducted. What is involved in that case is the current use of a loan and not its original use.

[29]          It is not the original use of the borrowed funds that counts but its current use. In the case at bar, the funds were borrowed to pay the cost of purchasing a house that was later sold. The acquisition cost of the house has not been paid in full by the vendors. They are still paying interest on that cost. Moreover, the sale price has not been paid in full by the subsequent purchasers. They are paying interest on that price. It would be difficult in my view to come to any conclusion other than that the interest paid by the vendors is being used for the purposes of the sale of the property and that the interest paid is in fact related to the interest received. Therefore, the current use of the borrowed money is to earn income. Is this a direct use? In this case, the answer to the first question answered the second.

[30]          I see nothing in the decisions cited by the agent for the respondent, including in particular Holotnak v. Canada (F.C.A.), [1989] F.C.J. No. 1027 and M.N.R. v. Attaie (C.A.), [1990] F.C.J. No. 527, that could lead to a different conclusion than this: the borrowed money is by virtue of the use to which it was put related to the income earned.

[31]          The appeal is allowed so as to permit the deduction of the interest paid on the $60,000 loan.

[32]          With respect to costs, this is a case where the taxpayer did not tell the truth at the outset, which led to wasted effort. In these circumstances, I believe it is appropriate to award the appellant only half the costs.

Signed at Ottawa, Canada, this 1st day of November 2000.

"Louise Lamarre Proulx"

J.T.C.C.

[OFFICIAL ENGLISH TRANSLATION]

[OFFICIAL ENGLISH TRANSLATION]

1999-1658(IT)I

BETWEEN:

HUGUETTE LEDUC,

Appellant,

and

HER MAJESTY THE QUEEN,

Respondent.

Appeals heard on July 24, 2000, at Montréal, Quebec, by

the Honourable Judge Louise Lamarre Proulx

Appearances

For the Appellant:                                Pierre Chartrand

Agent for the Respondent:                   Annick Provencher (Student-at-law)

JUDGMENT

          The appeals from the assessments made under the Income Tax Act for the 1992, 1993, 1994, 1995 and 1996 taxation years are allowed, with half of the costs, and the assessments are referred back to the minister of National Revenue for reconsideration and reassessment in accordance with the attached Reasons for Judgment.

Signed at Ottawa, Canada, this 1st day of November 2000.

"Louise Lamarre Proulx"

J.T.C.C.