William Landrey v. Minister of National Revenue, [1985] 1 CTC 2313, 85 DTC 275

Christie, ACJTC:—This appeal relates to the appellant’s 1978 and 1979 taxation years. There are three issues in respect of both years: first, is the appellant entitled to deduct the allowable business investment losses claimed; second, is he entitled to deduct certain interest paid by him; third, was the respondent justified in reassessing the appellant on the basis that he was liable to penalties regarding alleged unreported income.

In 1973 the appellant became involved in the swimming pool business. In 1975 Landrey Pools Limited (“the corporation’’) was incorporated under the laws of Ontario. The appellant held a majority of the shares and the rest were issued to his wife.

The company was not a success. The appellant and his wife borrowed money in aid of the corporation and on June 20, 1977, it issued a promissory note in his favour in the sum of $73,445. The note was payable on demand and bore interest at the rate of 15 per cent per annum. In his 1978 return of income the appellant makes reference to the promissory note and states that it was “sold” for $1 on December 31, 1978. He claimed an allowable business investment loss of $13,055. He also sought to deduct interest in the amount of $12,071 paid on the loans made to him and his wife the proceeds of which, as mentioned, were funnelled into the corporation. The same pattern was repeated in the appellant’s 1979 return except that the promissory note is dated December 31, 1978, and it is in the amount of $8,730. It was “sold” on December 31, 1979. For this year he claimed an allowable business investment loss of $5,202 and sought to deduct interest in the amount of $11,412.84 paid on money borrowed for the purposes of the corporation. The appellant subsequently reduced his claimed deductions for interest to $6,784.92 (1978) and $6,500.03 (1979) stating that these figures reflect interest on the amount of the money borrowed by him for the purposes of the corporation, the balance being properly attributable to his wife. She also made repayments on the borrowed money. Although the promissory notes were issued in favour of the appellant only, I deduced that they included the debts owed Mrs Landrey by the corporation regarding the amounts she borrowed for its purposes. If, therefore, the appellant is entitled to any allowable business investment losses, it is the amount claimed in his returns reduced in proportion to the amount that the promissory notes reflect debts of the corporation payable to Mrs Landrey. A photostatic copy of the two promissory notes was entered as Exhibit R-4 by counsel for the respondent. No evidence was forthcoming at the hearing to indicate that the indebtedness to which the notes relate arose at a time other than the dates appearing thereon.

In the notice of appeal to this Court which was prepared by an accountant acting as agent for the appellant, the latter is described as “a poor businessman and bookkeeper”. The only witness called at the hearing was the appellant. When asked by his agent if he was a good businessman, the appellant replied no. In the course of argument the appellant’s agent reiterated the appellant’s deficiency in this regard. I believe it. For example, during examination in chief the appellant appeared incapable of sorting out whether services rendered and materials supplied regarding swimming pools were by the corporation or on his personal account. There was evidence that contracts for pools were entered into between “Landrey Pools” and purchasers. Invoices were headed “Landrey Pools”. These documents were carry-overs from pre-incorporation days. The appellant said he did not have the funds to change the form of the documents. He also received cheques relating to swimming pools in his own name. The only financial statement prepared in respect of the corporation is one for the year ending March 31, 1976. Returns of income were not filed on behalf of the corporation in 1977, 1978 or 1979. In 1977 the corporation’s bank account was closed by its banker who told the appellant to take the business elsewhere. A new account was not opened, but banking transactions relating to the swimming pool enterprise were carried on by the appellant through a personal bank account. Counsel for the respondent, however, introduced a significant clarifying factor to this welter of confusion. At the commencement of cross-examining the appellant, counsel confronted him with his returns of income for 1977, 1978 and 1979. He pointed out they showed no business income. Counsel then asked the appellant in respect of each return whether it fully disclosed the latter’s income from all sources. He replied with an unqualified yes. The only source of income disclosed by the returns is employment income from the London Board of Education in the amounts of $24,739.65, $26,788.46 and $27,813.55 respectively. These returns did not include any claims for deductions related to the swimming pool enterprise other than the previously mentioned claims for allowable business investment losses and interest.

I have concluded that on balance the better view is that the commercial activities carried on in respect of swimming pools which are relevant to this appeal were carried on by the corporation under the direction and management of its majority shareholder, the appellant.

In reassessing, the respondent treated the advances made by the appellant to the corporation as reflected by the two promissory notes as debts which had become bad in 1977. In paragraph 6 of the reply to notice of appeal, the respondent states that the advances made by the appellant to the corporation “were a bad debt in 1977 and thus the appellant was deemed by paragraph 50(l)(a) of the Income Tax Act to have disposed of the debt in his 1977 taxation year for proceeds of disposition of nil”. The appellant has not at any time endeavoured to establish that the debts owed to him by the company had become bad. Paragraph 50(1)(a) provides:

50. (1) For the purposes of this subdivision, where

(a) a debt owing to a taxpayer and the end of a taxation year (other than a debt owing to him in respect of the disposition of personal-use property) is established by him to have become a bad debt in the year,

the taxpayer shall be deemed to have disposed of the debt or the share, as the case may be, at the end of the year and to have reacquired it immediately thereafter at a cost equal to nil. [Emphasis added.]

In his notices of objection and in the notice of appeal, the appellant took the position that he had incurred a business investment loss in 1978 and 1979 within the meaning of paragraph 39(l)(c) of the Act. What is relevant for the determination of this appeal in that paragraph provides that for the purposes of the Act a taxpayer’s business investment loss for a taxation year from the disposition of any property includes the amount of his capital loss for the year from a disposition after 1977 to a person with whom he was dealing at arm’s length of a debt owing to the taxpayer by a Canadian-controlled private corporation. There is nothing in the material received by the Court under subsection 170(2) of the Act, or in the reply to notice of appeal alleging that the disposition of the debts were not arm’s-length transactions. It was not raised in evidence at the hearing. Also, on the basis of the evidence of the financial condition of the corporation when the debts were disposed of there is no ground for concluding that there was an artificial creation of losses from the dispositions or an undue increase in the amount of the losses from the dispositions within the meaning of section 55 (now subsection 55(1)) of the Act. Section 55 was not mentioned prior to or raised at the hearing.

The first submission made by counsel for the respondent in argument was that in order for the appellant to have a business investment loss it “would have to be found that Landrey Pools Limited was carrying on business in 1978”. Although not specifically stated, I take it that this must also be the respondent’s position with respect to 1979. I disagree. There is nothing in the legislation to sustain this point of view. No authority was cited in support of it and I know of none. In my opinion a taxpayer who, in accordance with subparagraphs 39(l)(c)(ii) and (iv), disposes of a debt owing to him by a Canadian-controlled private corporation to a person with whom he was dealing at arm’s length has a business investment loss in the year of disposition even if the debtor corporation was totally dormant commercially in that year. The appellant is entitled to deduct allowable business investment losses as defined in paragraph 38(1)(c) of the Act in his 1978 and 1979 taxation years. The paragraph reads:

38. For the purposes of this Act,

(c) a taxpayer’s allowable business investment loss for a taxation year from the disposition of any property is /2 of his business investment loss for the year from the disposition of that property;

Unlike an allowable capital loss which for the most part can only be deducted against taxable capital gains, an allowable business investment loss can, by operation of paragraph 3(d) of the Act, be deducted against any source of income.

The next issue is whether the appellant is entitled to deduct interest paid on money borrowed by him and used for the purposes of the corporation. As reduced by him, it amounts to $6,784.92 in 1978 and $6,500.03 in 1979. Paragraph 20(l)(c) of the Act provides that 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, namely, an amount paid in the year pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from a business or property.

I am satisfied that the appellant borrowed substantial sums which were directed towards the needs of the corporation. He said that since 1977 the mortgage on the matrimonial home increased from $26,000 to $100,000 and that “every cent was used in regards to the pools’’. I am also satisfied that the interest in the amounts stated was paid on that borrowed money during the years under review pursuant to a legal obligation to do so. There is, however, authority for the proposition that if a source of the kind referred to in paragraph 20(l)(c) no longer exists, the right to deduct interest in computing a taxpayer’s income ends. In Deschenes v MNR, [1979] CTC 2690; 79 DTC 461, it was found that a hairdressing business in respect of which money had been borrowed was bankrupt and “no longer existed’’ thereby precluding the deduction of interest on the money. In Alexander et al v MNR, [1983] CTC 2516; 83 DTC 459, it was held that the business “had been terminated’’ and with it the right to deduct interest. The appellant in Lyons v MNR, [1984] CTC 2690; 84 DTC 1633, had borrowed money to purchase shares in a company with a view to earning income from them. He sought to deduct interest paid on the money in 1978 and 1979, but it was held that there was no source in those years because by then if the company existed at all it was ‘‘a worthless economic shell without hope of resuscitation’’.

I do not regard the corporation to have been, in 1978 and 1979, in the condition described in the cases just cited. True it was under the management of an individual whose business acumen has been described. Also it was very shaky financially. The evidence of the scope of its activities in those years was sparse. The appellant made mention of a contract for one Lahaquier being completed in 1978. There were dealings with Corinthian Pools of Canada Ltd. The respondent introduced in evidence (Exhibit R-5) copies of a number of cheques issued by Corinthian in favour of the appellant. The exhibit shows that during the summer months of 1978 seven cheques were issued in favour of the appellant totalling $5,326.65 and in those same months in 1979 eight cheques were issued in favour of the appellant totalling $5,864.35. The corporation had debts, but there were also receivables. In my opinion the state of the corporation at the relevant times was such that it cannot correctly be said that there was no source in being within the meaning of paragraph 20(l)(c) of the Act. The appellant is entitled to deduct the reduced interest claimed.

In reassessing with respect to the penalties the respondent relied on subsection 163(2) of the Act. The appellant’s liability to penalties is said by the respondent to have arisen by reason of omitting to report payments made by Corinthian Pools of $3,718 and $3,100 in 1978 and 1979 respectively. I have said that the activities carried on in respect of swimming pools which are relevant to this appeal were carried on by the corporation under the direction and management of the appellant. The payments made by Corinthian Pools were therefore income of the corporation and not in the hands of the appellant even though the cheques were made payable to him. This eliminates the basis upon which the alleged liability of the appellant to penalties rests.

The appeal is allowed and the matter is referred back for reconsideration and reassessment on the basis that the appellant is, in respect of his 1978 and 1979 taxation years,

(a) entitled to deduct the allowable business investment losses claimed on the reduced basis previously indicated,

(b) entitled to make the reduced deductions claimed in respect of interest paid by him, and

(c) is not liable to penalties.

The appellant is entitled to his party and party costs.

Appeal allowed.