J M Léger v. Minister of National Revenue, [1981] CTC 2334, 81 DTC 294

The Chairman:—The appeal of Mr J M Léger is from a tax assessment with respect to the 1977 taxation year. There are two distinct issues in this appeal. The first issue is the interpretation to be given to section 110.1 of the Income Tax Act, SC 1970-71-72, c 63, as amended, as it relates to methods to be used in computing the quantum of deductible interest and dividend income.

It is the appellant’s contention that the interest carrying charges must first be deducted from related interest income i.e. interest expenses should be netted against related interest income before determining the interest and dividend income deductible under section 110.1 of the Act.

In support of his contention, the appellant read into the record extracts of the 1977 tax guide, the supplementary budget papers of March 31,1977 and the 1978 Canadian Master Tax Guide (on file as written argument). The appellant contended that the proposed amendments referred to above were to eliminate a double interest deduction and that Parliament sought to relate interest income to interest expenses in the application of section 110.1 of the Act and suggests that the spirit of the law rather than the wording of the section should prevail.

To illustrate his point, the appellant included in his written argument the following computations of his interest and dividend income and expenses in the application of section 110.1 of the Act with his accompanying remarks:

Counsel for the respondent rightly pointed out that, however interesting may be the budget papers, the Canadian Tax Guide cited by the appellant or the Information Bulletins published by the Department of National Revenue expressing its opinions on certain provisions of the Act, they are not binding on the Board when the words of the pertinent section of the Income Tax Act are clear.

The dispositions of the Act which were applicable in 1977 are paragraph 110.1 (1 )(a) and subparagraph (b)(iv) which reads in part as follows:

For the purpose of computing the taxable income for a taxation year of an individual .. . there may be deducted from his income for the year an amount equal to the lesser of

(a) $1,000, and

(b) the amount by which the aggregate of

(1)

(ii) . . . and

(iii) . ..

exceeds

(iv) the aggregate of amounts deducted by him in computing his income for the year as or on account of interest on borrowed money used, or on an amount payable for property acquired, for the purpose of earning

(A) interest . . .

Counsel for the respondent produced as Exhibit R-1 schedule 4 of the appellant’s 1977 returns which shows a total of $1,000.90 as income from interest or dividends and carrying charges in the amount of $1,178.10, the details of which are found in Exhibit R-2.

It is the respondent’s position that had Parliament intended that subparagraph (iv) of subsection 110.1(1) of the Act be interpreted to mean that interest expenses should be netted against related interest income, the word “related” would have been included in the subsection.

Counsel for the respondent further suggested that Parliament specifically excluded from the deductions or netting out provisions of subsection (iv) certain incomes, as set out in subsection 110.1(2) of the Act. The respondent noted that the appellant’s interest and dividend income for 1977, which is slightly lower than the carrying charges in Exhibit R-2, does not come within any of paragraphs (a) to (j) of subsection 110.1(2) of the Act and must be deducted or netted out.

It is the respondent’s contention that Parliament did consider and indeed specified those amounts which were not to be deducted or netted in computing deductible interest income, pursuant to section 110.1 of the Act and to add the concept of relating and netting interest expenses to specific interest income in applying section 110.1 would be contrary to the working of the section and not in keeping with the intent of Parliament.

The issue, as suggested by the appellant, is really not one of principle but simply the difference in the methods used by the appellant and the respondent in calculating the deductible interest and dividend income when the interest income is less than the interest expense. The difference in the results of the two methods of calculating the deductible interest income disappears when the interest income is larger than the interest expenses by at least $1,000.

The appellant’s argument of netting interest expenses against related interest income is not without a logical foundation and it does reflect a generally accepted accounting principle.

However, if indeed the result arrived at by the respondent in computing the appellant’s deductible interest income is an anomaly or is not what Parliament intended, then the section of the Act should be amended accordingly. In the meantime, notwithstanding the various quotations which the appellant placed on record, and as stated by counsel for the respondent, the Board must determine the issue on the clear wording of subparagraph 110.1 (b)(iv) which does not make any reference to the possibility of netting interest expenses to related interest income and it would, in my opinion, be improper to so interpret the section of the Act. The appeal as to that issue must therefore be dismissed.

The second issue is whether an amount of $7,500, claimed by the appellant as a business loss or alternatively as a capital loss, is in fact deductible in the 1977 taxation year.

The details of the facts on the issue are to be found attached to a letter dated September 29, 1978, addressed to the District Taxation Office in Ottawa (on file). In summary, the pertinent facts are that the appellant, at the invitation of a close friend, became involved in a venture in which Flashguard Limited was to be the exclusive representative of an American corporation known as Flashguard Inc. for the distribution of Flashguard security systems in Canada.

On December 14, 1976, the appellant purchased in trust a debenture for $15,000 ($14,944 for the debenture and $56 for 224 shares of capital stock). The appellant’s share of the purchase was $7,500 i.e. $7,472 for the debenture and $28 for 112 shares. The interest on the debenture was at 8%, payable semi-annually and due on June 30, 1981.

The evidence on cross-examination was that the appellant had never been in the alarm business and was not an employee of Flashguard Limited but did attend shareholders’ meetings of that company. It was also established that the appellant was not in a lending business of any kind.

The sales of the alarm systems in Canada were not successful and the company incurred large deficits to the point that in October 1977, the company closed its doors and the assets were distributed either to the landlord for payment of lease of the premises, to chattel mortgage holders or to other creditors.

Submissions

The appellant submitted that the amount of $7,500 paid by himself for the debenture was a business loss that he incurred and that the debt became bad at the time Flashguard Limited ceased its operations in October 1977, within the meaning of paragraph 50(1)(a) of the Income Tax Act.

The appellant considered that the loss sustained was a business loss in the sense that it was an adventure in the nature of trade. The appellant alleges that the debenture was not purchased for the 8% interest that it would generate but was purchased speculatively, in the hope that the product would be marketed successfully or failing that, the patent and the company assets could be sold at a profit.

In claiming that the business loss was incurred in 1977, the appellant read into the record clause 3 of the debenture (not filed as exhibit), the transcript of which reads as follows:

If the company makes default in payment of the interest of this or any other debenture of the series and such default shall have continued for a period of ninety days, or if the company ceases to carry on its business or commits any act of bankruptcy or becomes insolvent or goes into liquidation or makes a general assignment for the benefit of its creditors or otherwise acknowledges its insolvency, the whole of the principal amount, of the principal monies hereby secured shall forthwith become due and payable, together with all of the interest thereon and on the balance thereof from time to time unpaid to the date of actual payment.

In support of his submissions that he had sustained a business loss in 1977, the appellant referred to the following cases:

1. Her Majesty the Queen v Douglas Lloyd Anderson and Jean Emily Buckingham, and Joyce E McDonald and David C McDonald v Her Majesty the Queen, [1973] CTC 606; 73 DTC 5444;

2. Sydney Bossin v Her Majesty the Queen, [1976] CTC 358; 76 DTC 6196;

3. MNR v James A Taylor, 9 Tax ABC 358; 56 DTC 1125;

4. MNR v Henry J Freud, [1968] CTC 438; 68 DTC 5279.

Alternatively, the appellant submitted that if the $7,500 was not a business loss, then it was a capital loss sustained in 1977 and $3,750 should be deducted as a Capital loss.

The respondent’s position is that the appellant’s loss was not a business loss but a capital loss which however was not sustained in 1977, the pertinent taxation year.

Counsel for the respondent stressed the fact that the appellant’s major involvement with Flashguard Limited was the acquisition of a debenture, which is a loan or an advance to the company, and the appellant’s rights in the company as a debenture holder are governed by the terms of the debenture.

The respondent read into the record clause 1 of the debenture:

Paragraph 1, For value received Flashguard Limited, hereinafter called the company, hereby acknowledges itself indebted and promises to pay Jean Maurice Leger, trustee or other a registered holder thereof for the time being, hereinafter called the holder hereof, the principal amount of $14,944 in lawful money of Canada at the head office of the company, in the City of Oakville, Ontario, which amount shall be payable to the extent of $14,944 on June 30, 1981 or on such earlier dates as the principal amount may become due in accordance with the provisions hereinafter set out and to pay interest on the said principal amount or on the balance in like money and at the same place from the date hereof at the rate of eight per cent per annum semi-annually on the 31st day of December, 1976 and on the 30th day of June in each year.

Paragraph 8 of the debenture was also read into the record:

The holders of the debenture of the series shall have power by extraordinary resolution to waive any breach by the company of any of the provisions contained in the debenture or any default by the company in the payment of the interest represented by the debentures.

The respondent contends that there was no market for the debenture and that all the appellant could reasonably expect from the debenture was interest income and the return of capital on June 30, 1981. The profit contemplated by the appellant from his share holdings on the marketing of the product or the sale of the patent on which the appellant bases his argument that the transaction was in the nature of trade is stated by counsel for the respondent as being a very minimal portion of the appellant’s investment, viz. $28 out of $7,500.

Counsel further points out that other than as a shareholder, the appellant was not actively engaged in the operations of the company and was not himself in the business of lending money and concludes that the advance made by the appellant can only have been made as a Capital investment.

I am satisfied on the basis of the evidence and the case law referred to by the appellant, the facts of which are distinguishable from those of the instant appeal as well as the cases cited by counsel for the respondent that the advance made by the appellant was capital in nature and that the loss sustained was a capital loss. The remaining issue is whether or not this capital loss was sustained in 1977.

The appellant suggested that the respondent admits that Flashguard Limited ceased its operations in October 1977 and that, according to Interpretation Bulletin 159R2 of the Department of National Revenue, the debt would have become bad at the time the company had disposed of its operating assets.

As suggested by counsel for the respondent in citing Ernest G Stickel v MNR, [1972] CTC 210; 72 DTC 6178, however useful may be Interpretation Bulletins, they are not meant to overrule the Income Tax Act nor to be a substitute for the decisions of the Court or Board which must be rendered on the basis of the pertinent sections of the Act as they apply to the facts of each individual case.

In this instance, Flashguard Limited was an incorporated company in which the appellant, as a debenture holder, had certain rights. In my opinion, these rights were not directly related to the profits to be derived from the production of alarm systems and the disposition of Flashguard’s operational assets did not abolish the appellant’s rights as a debenture holder in the corporation.

The corporation had the one asset which, in my view, was more directly related to the appellant’s debenture and that is its charter. Although the principal and interest on the appellant’s debenture may well have become due in 1977, it does not necessarily follow that the debt became bad at that time.

I agree with counsel for the respondent that the corporation might well have found a new source of finance to continue the production of alarm systems or some other product or arrive at some other way which might generate income to pay off the appellant’s debenture. Although the appellant identified his debenture with the alarm systems in which he had great hopes, his rights as a debenture holder rested in the company itself. Only when the company effectively surrendered its charter voluntarily or that it was automatically surrendered after the company had been inoperative for the period of three or more years, as required by the Corporations Act of Ontario, could the appellant rightly claim that he had no hope of recovering his investment; that he had no recourse against the corporation which could not pay off its debenture and conclude that the debt was bad.

In 1977 the corporation had not surrendered its charter nor had it been inoperative for three consecutive years, and though the debt may have become due in 1977, it had not yet become a bad debt.

For these reasons, the appeal is dismissed.

Appeal dismissed.