Russell Plawiuk v. Her Majesty the Queen, [1994] 1 CTC 2077

Sobier, J.T.C.C. (orally):—The appellant appeals from the assessments for the 1986,1987,1988, and 1989 taxation years wherein the Minister of National Revenue (the "Minister") disallowed in the 1987, 1988, and 1989 taxation years interest expenses on a loan used to purchase common shares of Seven-Up Canada Inc. (the "company") and with respect to his 1986 taxation year disallowed the non-capital loss carryback from 1988.

An agreed statement of facts was filed by the parties and I direct that paragraphs 1 to 16 inclusive, without reference to tabs, be incorporated in these reasons as if set out herein in full.

1. The appellant is a Canadian resident for tax purposes. His social insurance number is 426 277 729. Throughout the relevant time period, the appellant was an executive in the beverage and bottling business.

2. The appellant is appealing from notices of reassessment of the Minister of National Revenue (the"Minister") having numbers 2083068, 2083069, 2083070, and 2083071 for the 1986, 1987, 1988 and 1989 taxation years, respectively, of the appellant (collectively referred to as “the reassessments" or individually as "the reassessment"). The reassessments are each dated September 3, 1991 and were confirmed by a notification of confirmation of the Minister dated May 8, 1992.

3. The appellant and his business partners borrowed the sum of $6,000,000 (U.S.) from Crown Financial Corporation in 1987 (the"loan"), pursuant to the terms of a written agreement (the" agreement"). This agreement is entitled Promissory Note with Confession of Judgment" and is dated June 23, 1987. The appellant’s share of the loan was $1,200,000 (U.S.). The agreement provided that the loan would bear interest at the rate of U.S. prime (First Pennsylvania Bank) plus two per cent unless there was an event of default thereunder, in which case the interest rate would increase to U.S. prime (First Pennsylvania Bank) plus four per cent. The agreement further provided that interest would be compounded annually on June 1. A stock pledge agreement, dated June 23, 1987, was entered into to provide security for the loan.

4, Crown Financial Corporation (the lender") is a corporation incorporated under the laws of the United States. The lender is a corporation related to Crown Cork & Seal Co., a supplier of Seven-Up Canada Inc. At all relevant times, the appellant and the lender were at arm's length.

5. The funds obtained under the loan were used by the appellant and his business partners to acquire common shares of Seven-Up Canada Inc., a corporation incorporated under the laws of Canada. In particular, the appellant purchased 100 common shares of Seven-Up Canada Inc.

6. As of December 31 in the years 1987, 1988 and 1989, interest in the amounts of $94,424 (Canadian), $179,682 (Canadian), and $219,120 (Canadian), respectively, had accrued in respect of the loan.

7. As of December 31, 1989, the appellant had not made any payments of principal or interest to the lender in respect of the loan.

8. In 1992, the appellant repaid the following amounts of principal and interest on the loan:

Repayment of original loan of
$1,200,000 (U.S.) converted at
19.301 percent	$1,431,612
Interest expense for 1987-92	1,166,417
Total	$2,598,029

9. In filing his tax returns for the subject taxation years, the appellant claimed interest expenses in respect of the accrued interest on the loan, namely the amounts of $94,424 in 1987, $179,682 in 1988 and $219,120 in 1989, pursuant to paragraph 20(1)(c) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72,

c. 63) (the "Act").

10. In filing his tax returns for subsequent taxation years, the appellant continued to claim interest expenses in respect of accrued interest on the loan, namely the amounts of $226,979.71 in 1990, $282,061.07 in 1991 and $164,149.41 in 1992.

11. The appellant’s 100 common shares of Seven-Up Canada Inc. purchased in 1987 were redeemed in 1992. The proceeds on the redemption were as follows:

Paid-up capital portion	$ 790,895
Deemed dividend per subsection 84(3)	1,555,878
Total	$2,346,773

12. The appellant reported income in the taxation years indicated from the following sources in the following amounts:

	Employment	Interest		Taxable dividend
1986	$ 68,334.43		—	—
1987	$116,123.00	$	14.00	—
1988	$153,295.52		—	—
1989	$ 73,295.24	$ 1,066.49		—
1990	$150,284.38	$ 4,681.55		—
1991	$120,236.33	$ 5,726.00		—
1992	$182,256.34	$73,008.22		$5,842,505.55

13. The appellant filed a request for loss carrybacks requesting that non-capital losses realized in his 1988 taxation year (as a result of the aforesaid interest expense) be carried back to offset his taxable income realized in 1986.

14. The reassessment in respect to the appellant's 1986 taxation year disallowed the non-capital loss carryback from 1988 claimed by the appellant on the basis that this loss had been reduced to nil in the reassessment in respect of the appellant's 1988 taxation year.

15. The reassessment of each of the appellant's 1987, 1988 and 1989 taxation years disallowed the deductions claimed for interest expenses on the basis that the method regularly followed by the appellant in computing his income for each of the relevant years was the cash method. Thus, it was the Minister’s position that since the interest was not actually paid by the appellant in the years in which it was claimed, the interest expenses claimed were not allowable as deductions from income within the meaning of paragraph 20(1)(c) of the Act until the year in which the interest expense was actually paid.

16. The appellant filed notices of objection to the reassessmentson October 29, 1991 to which the Minister responded by confirming his reassessments byway of a notification of confirmation dated May 8, 1992.

In addition the appellant gave evidence establishing that while the management group at the company originally purchased 50.1 per cent of the outstanding shares, one of the group died within three and a half months of the purchase and therefore the deceased shareholder's shares were held by the executors of his estate who were not members of the management group. Evidence was also adduced that there were covenants in various shareholders' or loan agreements which either required the approval of the holders of 66 and A per cent of the outstanding common shares before dividends could be paid or requiring the approval of the company's bankers to such payment.

It was conceded that the money was borrowed for the purpose of earning income from property, namely the shares, that the interest expense was reasonable even though the expenses exceeded any dividends paid. It was also conceded that any income earned would have had as its source the common shares purchased.

It was also shown that through the stock pledge agreement and promissory note with confession of judgment that interest was payable annually. The appellant also stated that these agreements were in default for failure to pay interest as required and that the lenders had commenced an action to enforce its rights in the summer of 1989, which action ended in March 1992 when the shares were disposed of.

The issue here revolves around the interpretation of paragraph 20(1)(c) of the Income Tax Act, the applicable portions of which read as follows:

20 (1) Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer's income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:

(c) 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. . . .

The appellant contends that the method regularly followed by him in computing his income was the accrual method which would allow him to deduct the amounts of interest which were payable in each year in accordance with the aforesaid promissory note.

The Minister maintains that the proper method is the cash method which would only allow the interest to be deducted when paid.

The agreed statement of facts shows that $14 interest income was earned in 1987, the source of which cannot be absolutely identified but was alluded by counsel for the Minister to have been refund interest paid by the Minister. No interest income was earned in 1988 and $1,066.49 interest income was earned in 1989. The 1989 interest income had as its source a daily interest savings account at the Royal Bank of Canada. In all of the years in question the appellant earned employment income but did not earn income from taxable dividends.

The Court was afforded by both counsel a look at the legislative history of interest deductibility showing the evolution from interest being deductible only on a cash basis to the present paragraph 20(1)(c).

It is the "method" referred to in paragraph 20(1)(c) which is under scrutiny.

In Industrial Mortgage and Trust Co. v. M.N.R., [1958] C.T.C. 106, 58 D.T.C. 1060, a decision of Mr. Justice Thurlow of the Exchequer Court of Canada, the question of "method" was raised. At page 114 (D.T.C. 1064) Mr. Justice Thurlow stated:

This argument raises a question as to what is meant by the word "method" in paragraph 6(b) and a further question as to whether or not the appellant regularly followed a method of computing its profit. As I interpret it, the word "method" is not used in paragraph 6(b) in any narrow or technical sense but simply means the system or procedure which the taxpayer has regularly followed in computing his profit. The system or procedure, in my opinion, may be made up of a number of practices, and I can see no valid reason why, in a diverse business such as that of the appellant, such system or procedure could not include different practices for accounting for revenue from different activities or sources, depending on the nature of such activities or sources and of the revenues therefrom, and still be regarded as a "method" within the meaning of that word in paragraph 6(b). In my opinion, the practices followed by the appellant did amount to a^method" within the meaning of the section and, as that method had been followed by the appellant without change for the seven years immediately preceding 1949 and for 1949 as well, I have no hesitation in concluding that it was the" method" regularly followed by the appellant in computing its profit within the meaning of paragraph 6(b).

Therefore one must examine what method the appellant used. He used the accrual method and used it consistently from 1987 to the date the principal and interest on the loan were fully paid.

The question of looking at the source of interest income for the years under appeal does not appear to shed much light on the issue.

The sources for these amounts of interest income were in no way connected with the source of potential income from the shares. Paragraph 20(1)(c) refers to deducting interest which is wholly applicable to a source (business or property) and, as stated, this source was to be the shares.

The Minister's position is that since all sources of income earned by the appellant in the years in question, that is employment income and interest income from a bank account, are reported on a cash basis, then it follows that interest expense must also be taken on a cash basis.

I find no merit in this argument. The Act deals with taxing income from various sources: employment, business, or property.

Here we are dealing with property as a source; therefore, the method of reporting employment income is irrelevant. In addition it has been made clear that various sources may be treated differently, that is reporting income and taking deductions from one source may be treated differently than from another source. (See Industrial Mortgage and Trust, supra.)

The fact that the appellant received some interest income from a bank's daily interest savings account should in no way be determinative of how he should be required to treat interest expense with respect to potential income from an entirely different source.

Such action could require investors who have small bank accounts producing insignificant income to be required to use the cash method with respect to interest on borrowed money used to earn dividend or other income.

This brings me to the Minister's other argument which is that because the provisions of paragraph 82(1)(a) of the Act require that taxable dividend income be reported in the year received, the interest paid to earn this income may only be deducted in the year when paid. In other words, that he must report the interest expense on the same basis as the income is to be reported.

This argument is also not tenable. What we must not lose sight of is the plain language in paragraph 20(1)(c) which allows the taxpayer to choose a method so long as he uses that method regularly.

From the beginning, that is 1987, he used the accrual method even when he earned no interest income (except the $14 which, as stated, was perhaps refund interest paid by the Minister) and he used that method regularly.

For the above reasons the appeals are allowed with costs and the matter referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the appellant be allowed the deductions from income for his 1987, 1988, and 1989 taxation years with respect to interest accrued on money borrowed to acquire the shares of Seven-Up Canada Inc. and so as to allow the carry back of the non-capital loss incurred in the 1988 taxation year to the appellant's 1986 taxation year.

Appeal allowed.