Gilles Portugais v. Her Majesty the Queen, [1994] 1 CTC 2665, 94 DTC 1482

Brulé, J.T.C.C.:—These appeals, heard under the General Procedure provisions of this Court, involve the appellant’s 1988 and 1989 taxation years. Objection has been raised to assessments by the Minister of National Revenue ("Minister") in these years involving rental losses, interest expense, capital losses and penalties.

Facts

Among other endeavours the appellant was a partner in a venture called Lys Enterprises. He was not active and had difficulty in obtaining financial information. Submitted to the Court were accounts sharing a loss to the appellant of $8,778.94 in 1988. No statements were obtainable in 1989 and hence no loss was claimed.

The appellant incurred interest costs on loans used to finance two investments. Evidence showed there was an interest amounting to $50,000 which the appellant made in 587956 Ontario Ltd. This was financed by cashing in an RRSP account and borrowing the remainder. Subsequently the loans were consolidated into a mortgage on the appellant’s residence. This mortgage was increased to raise funds to invest in another company, Diopter Technology Inc. ("Diopter"). While the interest expense claimed was $6,371.38 in 1988 and $11,084.53 in 1989 no documentary evidence as to the actual amount of interest paid was adduced at trial.

Diopter was a company incorporated in the State of Virginia. It carried on the business of eyeglass lenscasting processes. The appellant hoped to secure exclusive rights for the lenscasting technology for Canada, which accounted for his investing in this company. Diopter went out of business and the appellant claimed a capital loss on his investment.

Issues

There are four issues to be decided in these appeals. They are as follows:

1. whether the rental losses incurred by the appellant in his 1988 taxation year are deductible under subsection 9(2) or the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act");

2. whether the interest expense incurred to finance the appellant's investments in the 1988 and 1989 taxation years can be deducted under paragraph 20(1 )(c) of the Act;

3. whether the capital losses made by the appellant in the 1989 taxation year are deductible under paragraph 40(1 )(b) of the Act;

4. lastly, whether the Minister has properly assessed penalties under subsections 162(1) and (2) of the Act.

Rental losses

The appellant can be described as a passive investor and had no management responsibility whatsoever in the venture. The evidence shows that no partnership agreement was ever drafted. However, the financial statement indicates that the appellant's share in the partnership amounted to 30 per cent. Losses, as indicated above, were claimed at $8,778.94. The Minister claimed a deficiency in the financial statements both as to property taxes and a different year end for part of the operation.

There are two elements involved in such circumstances. The first is the provision in subsection 9(2) of the Act which sets out the general definition of a business loss. It reads:

9 (2) Subject to section 31, a taxpayer's loss for a taxation year from a business or property is the amount of his loss, if any, for the taxation year from that source computed by applying the provisions of this Act respecting computation of income from that source mutatis mutandis.

The second element is the onus of proof.

The basic principle that the Crown has the obligation to disclose to the taxpayer the precise findings of fact and rulings of law on which the reassessment rests was established in Johnston v. M.N.R., [1948] S.C.R. 486, [1948] C.T.C. 195, 3 D.T.C. 1182, at pages 489-90 (C.T.C. 203, D.T.C. 1183) where it was stated that:

The allegations necessary to the appeal depend upon the construction of the statute and its application to the facts and the pleadings are to facilitate the determination of the issues. It must, of course, be assumed that the Crown, as is its duty, has fully disclosed to the taxpayer the precise findings of facts and rulings of law which have given rise to the controversy.

It is a basic principle of tax law that the appellant has the burden of establishing that the Minister's reassessment is incorrect in law and in fact. The Honourable H.F. Gibson summarized in what circumstances the onus will be reversed in an article entitled "An Overview of Income Tax Litigation", [1983] Conference Report 967. At page 971 he stated:

Speaking generally further, it is a correct statement of the law in my view that the Minister, the Crown, can rely on facts other than those on which the assessment is based or are not contained in either the notice of objection or the notice of confirmation, but the Minister, the Crown, must plead such other facts and prove them to succeed at the trial of the dispute.

In sum, therefore, the assumptions of fact which the Minister, the Crown, may assume in pleadings and in respect of which the taxpayer has the onus to demolish, that is, one or all of them, may be found in the following documents, and are set out in them and are part of the record for the Court to consider: (1) the notice of assessment and the T7W accompanying the assessment; (2) the notice of objection; and (3) the notice of confirmation. Any other facts assumed by the Minister, the Crown, that are not found in those documents and therefore are not part of the record at trial, must be pleaded and proved by the Minister, the Crown.

The Minister’s notice of reply does not contain any assumption of facts on which the reassessment was based. This is especially notable given that during the objection stage the appellant claimed the deductibility of rental losses and the financial statement were filed with the claim. In my opinion, the Minister should have raised the inaccuracies in the financial statement in his reply. Had this been done, the appellant would have been in a position to disprove the Minister's allegations of fact. Having failed to raise these assumptions of fact, the Minister must therefore prove that the property tax expense was not accurate. The Minister did not satisfy this onus. Nor did he raise any allegation that the property tax expense was not reasonable in the circumstances pursuant to section 67 of the Act. Consequently, I believe that the appellant should be allowed to deduct rental losses for the 1988 taxation year.

Interest expense

As set out above the appellant incurred certain interest costs for the investments he made. It is necessary to consider the provisions in the statute covering this.

Pursuant to subparagraph 20(1 )(c)(i) of the Act, for an amount of interest to be deductible, the borrowed money must be used for the purpose of earning income from business or property. It reads:

20 (1)(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 (other than borrowed money used to acquire property the income from which would be exempt or to acquire a life insurance policy) . . . .

The popular case on deductibility of interest expense is the judgment of the Supreme Court of Canada in Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32, [1987] 1 C.T.C. 117, 87 D.T.C. 5059. In this case, the taxpayer trust borrowed money in order to make capital allocations to the trust's beneficiary rather than liquidate certain capital properties of the trust, which the trustee found to be more commercially inadvisable. The Supreme Court of Canada established certain principles which I find useful to reproduce here.

As is generally the case with tax appeals, the onus is on the taxpayer to show that the borrowed money qualifies for the deduction. As pointed out by Chief Justice Dickson at page 45 (C.T.C. 124, D.T.C. 5064):

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.

The determination of deductibility of the interest expense entails two tests: (1) use, and (2) purpose.

It is the direct use of borrowed funds that determines the deductibility of interest expense. In the words of Chief Justice Dickson at pages 53-54 (C.T.C. 129, D.T.C. 5067):

In my view, the text of the Act requires tracing the use of borrowed funds to a specific eligible use, its obviously restricted purpose being the encouragement of taxpayers to augment their income-producing potential. This, in my view, precludes the allowance of a deduction for interest paid on borrowed funds which indirectly preserve incomeearning property but which are not directly “used for the purpose of earning income from . . . property”.

The direct use of funds is traced by following them from the lender to the investment to which the funds are applied. Such was decided in the case of The Queen v. Attaie, [1990] 2 C.T.C. 157, 90 D.T.C. 6413 (F.C.A.). Professor V. Krishna in his book The Fundamentals of Canadian Income Tax, 4th ed., describes the test to determine whether funds were used indirectly at page 384 as follows:

The indirect use of funds involves their having been applied to facilitate the investment of other funds in an income producing process.

The second part of the test is whether the funds were borrowed for the purpose of earning income from business or property. Actual income gain is irrelevant. Dickson, C.J.C., made the following comments at page 46 (C.T.C. 125, D.T.C. 5064):

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 in using the borrowed money in a particular manner: Auld v. M.N.R. (1962), 28 Tax A.B.C. 236, 62 D.T.C. 27 . . . . Consequently, the focus of the inquiry must be centered on the use to which the taxpayer put the borrowed funds.

It is also the current use of the borrowed funds that determines the deductibility of interest expense. Dickson, C.J.C., approved the principle stated in Trans-Prairie Pipelines Ltd. v. M.N.R., [1970] C.T.C. 537, 70 D.T.C. 6351. As he pointed out at page 52 (C.T.C. 128, D.T.C. 5066) of Bronfman, supra:

In that case, as I have already indicated, Jackett, P. relied on the proposition, perfectly correct in so far as it goes, that it is the current use and not the original use of borrowed money that determines eligibility for a deduction. As stated previously, however, the fact that the taxpayer continues to pay interest does not inevitably lead to the conclusion that the borrowed money is still being used by the taxpayer, let alone being used for an income-earning purpose.

In Haig v. M.N.R., [1972] C.T.C. 2562, 72 D.T.C. 1465 (T.R.B.), the appellant, a director and key employee of a steel company, was allowed to deduct the interest paid on the money borrowed to purchase shares in his employer's company although no dividends were paid until some years later. The Minister had disallowed the interest deduction on the ground that they were acquired in the hope of capital accretion. The Court found that the evidence was clear and the appellant credible. The appellant's intention was to realize income by way of dividends on the shares held by him.

In the case of Goulardv. M.N.R., [1992] 1 C.T.C. 2396, 92 D.T.C. 1244 (T.C.C.), Beaubier, J., allowed the deduction of the interest expense that the appellant incurred to purchase shares in a company. The loan mechanism was as follows: the appellant subscribed for the shares of three separate corporations, all of which were engaged in the development of real estate. In each case, the pattern was the same. Each corporation borrowed funds from its bankers on a "daylight loan" basis and each reloaned such borrowed funds to the taxpayer to enable him to take up the subscription of shares involved. Using the funds received back from the taxpayer, each corporation was then able to repay its bank loan.

The taxpayer’s appeal was allowed in part. He was only entitled to deduct interest on shares that were actually issued (that is, paid for in full). The Court found that concerning the shares that were issued, the interest paid was reasonable and the underlying shares were acquired by the taxpayer with a view of earning income by way of dividends.

The Minister's counsel raised the case of Scott v. M.N.R., [1989] 1 C.T.C. 2305, 89 D.T.C. 218 (T.C.C.). In this case, the appellant borrowed money and reloaned it to the corporation as a non-interest bearing shareholder's loan. The Court found that the funds were not used for the purpose of gaining income. The evidence indicated that the borrowed funds were used by the taxpayer to acquire noninterest bearing notes of the corporation, but not to acquire dividend income from them. As pointed out by Taylor, J., at pages 2306-07 (D.T.C. 219):

Mr. Scott, with the borrowed and then loaned funds, acquired a property—the noninterest bearing note from the corporation. I do not believe that can be regarded as a source of income from which the interest paid which is at issue can be deducted . . . .

In Kyrès v. M.N.R., [1992] 2 C.T.C. 2214, 92 D.T.C. 1958 (T.C.C.), Tremblay, J., disallowed the deductibility of interest on the ground that the company in which the taxpayer invested had gone bankrupt. Without the existence of a company the interest is not deductible.

The appellant did not present any documentary evidence as to what amount of interest was actually paid. Frank Portugais, the appellant’s son, described a letter from Central Guarantee Trust which recorded the amount of interest paid by the appellant. Such letter was not admitted as evidence on objection by the Minister's counsel. No evidence whatsoever was brought concerning the interest paid to Hong Kong Bank. However, both the appellant and Frank Portugais gave a credible and plausible testimony as to the interest having been paid.

The Act requires the taxpayer to keep proper accounting records to support the calculation of taxes to be paid.

Subsection 230(1) of the Act is the general provision that requires a taxpayer to keep books and records. It reads as follows:

230 (1) Every person carrying on business and every person who is required, by or pursuant to this Act, to pay or collect taxes or other amounts shall keep records and books of account (including an annual inventory kept in prescribed manner) at his place of business or residence in Canada or at such other place as may be designated by the Minister, in such form and containing such information as will enable the taxes payable under this Act or the taxes or other amounts that should have been deducted, withheld or collected to be determined.

There is no requirement that accounts or records be kept in any particular form. The taxpayer is only required to keep accounts sufficient to determine the income that is taxable and the amount that is owing.

In the case under review, the appellant failed to keep books and records to establish what amounts of interest should have been deducted in the calculation of taxes owing for the 1988 and 1989 taxation years. As a result these claims for interest expense will be dismissed.

Capital losses

As set out above the appellant sought to claim capital losses when Diopter no longer existed as a corporation.

The corporate existence of Diopter was terminated in September 1, 1987 due to its failure to pay annual fees and the capital investment of the appellant was not redeemed, purchased or otherwise returned. According to the share register, the appellant paid $25,200 (U.S.) for the 2,500 shares.

A taxpayer's capital loss from a disposition of property is the amount by which the adjusted cost base and selling expenses exceed the proceeds of disposition (paragraph 40(1)(b) of the Act). A capital loss arises upon the disposition of capital property (subsection 39(1) of the Act). In essence, section 39 states that a capital gain/loss arises only on the disposition of property. The term "disposition" is therefore crucial to the capital gain/loss scheme. The term is not defined in the Act.

The term “disposition” or "to dispose of" has been broadly defined by case law. It includes the meaning of destruction and termination. As Pratte, J., held in the case of The Queen v. Compagnie Immobilière BCN Ltée, [1979] 1 S.C.R. 865, [1979] C.T.C. 71, 79 D.T.C. 5068 at page 878 (C.T.C. 79, D.T.C. 5075):

. . . the verb "to dispose of", in its first meaning, encompasses the idea of destruction; one of the meanings of the verb "to destroy” is "to put an end to, to do away with". . . .

The Australian High Court in Henty House Proprietary Ltd. v. Federal Commissioner of Taxation (1953), 88 C.L.R. 141, at page 151 (Aust. H.C.) explained the meaning of the word "disposition" as follows:

The entire expression "disposed of", "lost" or "destroyed" is apt to embrace every event by which property ceases to be available to the taxpayer for use for the purpose of producing assessable income, either because it ceases to be his, or because it ceases to oe physically accessible to him, or because it ceases to exist . . . the words “is disposed of" are wide enough to cover all forms of alienation . . . and they should be understood as meaning no less than “becomes alienated from the taxpayer", whether it is by him or by another that the act of alienation is done.

This passage was referred to by Noël, J., in Victory Hotels Ltd. v. M.N.R., [1962] C.T.C. 614, 62 D.T.C. 1378 (Ex. Ct.).

In the case at bar, evidence was adduced to show that Diopter was dissolved in September 1, 1987. Case law has defined the term "disposition" or "to dispose of" very broadly. In essence, it includes any event where the property ceases to exist. This is what in effect happened to the shares of Diopter; they ceased to exist when the company was dissolved. As a result, since the shares are deemed to have been disposed of in 1987, the appellant is not entitled to deduct capital losses in the 1989 taxation year.

Penalties

The appellant submitted that the penalties imposed on him are harsh considering the health problems he was undergoing in 1987,1988 and 1989. He declared that he was suffering from throat cancer and filing a tax return was not his priority.

The Court must consider the provisions of the Act, especially subsections 162(1) and (2) which read as follows:

162 (1) Every person who has failed to file a return as and when required by subsection 150(1) is liable to a penalty equal to the aggregate of

(a) an amount equal to five per cent of the tax that was unpaid when the return was required to be filed; and

(b) the product obtained when one per cent of the tax that was unpaid when the return was required to be filed is multiplied by the number of complete months, not exceeding twelve, in the period between the date on which the return was required to be filed and the date on which the return was filed.

(2) Every person

(a) who has failed to file a return of income for a taxation year as and when required by subsection 150(1),

(b) on whom a demand for a return for the year has been made under subsection 150(2), and

(c) who, at the time of failure, had been assessed for a penalty under subsection (1) or this subsection in respect of a return of income for any of the three preceding taxation years,

is liable to a penalty equal to the aggregate of

(d) an amount equal to ten per cent of his tax for the year that was unpaid when the return was required to be filed, and

(e) the product obtained when two per cent of the tax for the year that was unpaid when the return was required to be filed is multiplied by the number of complete months, not exceeding 20, from the date on which the return was required to be filed to the date on which the return was filed.

It is established by case law that the Court cannot interfere with subsection 162(1) penalties unless it is shown that the return was not late-filed or unless it is established that the penalty was incorrectly calculated.

In Meikar v. M.N.R., [1979] C.T.C. 2810, 79 D.T.C. 683 (T.R.B.), Bonner, J. made the following comments at page 2811 (D.T.C. 684):

I am of the view that, save in a case where the amount of tax upon which the five per cent penalty has been calculated has been shown to be excessive, it is not open to this board to interfere with a penalty imposed under subsection 162(1) unless it is established that there was no failure to make a return on time.

The same was said in Eyamie v. M.N.R., [1983] C.T.C. 2708, 83 D.T.C. 649 (T.C.C.) by Christie, A.C.J., at page 2710 (D.T.C. 651):

Again, even assuming that the reason for the late filing was dereliction of duty on the part of one or more of the accountants retained by the appellant, this does not afford a ground for allowing the appeal in respect of the penalty. On this aspect of the appeal, it is also my opinion that there is no jurisdiction in this Court to allow the appeal against the penalty.

Conclusion

The appeals are allowed on the basis that:

1. the rented losses are allowed;

2. the interest expenses to finance the appellant's investment are dismissed;

3. the claim for capital losses is dismissed;

4. the appeals against the penalties are dismissed.

The matter will be referred back to the Minister for reconsideration and reassessment. No costs are allowed to either party.

Appeals allowed in part.