Romolo Fontana v. Minister of National Revenue, [1981] CTC 2896, 81 DTC 803

D E Taylor:—This is an appeal heard in Toronto, Ontario, on September 24, 1981 against income tax assessments for the years 1973, 1974 and 1975 In which the Minister of National Revenue added amounts of $11,858, $89,384 and $89,485 respectively to the appellant’s income, and described these increases as “Net Shareholder Loan from Romy Ornamental Steel Ltd.” The respondent relied, inter alia, upon subparagraph 15(2)(a)(ii) of the Income Tax Act, SC 1970-71-72, c 63, as amended.

The appellant is the controlling shareholder and president of Romy Ornamental Steel Limited (“Romy”). He testified that after Romy had operated for several years, it was successful and needed larger factory space. In about 1972 he undertook to build the new factory personally, but to do so he borrowed about $127,000 from the company. Interest on the “factory loan” was paid by him to the company on a regular basis, and reported as income by Romy. While the majority of the available space was occupied by Romy, a portion of it was leased to a third party. He had separately advanced funds to Romy, and had not charged or been paid interest on these amounts. Commencing in 1974, he had borrowed other funds from the company for the express purpose of building a house for himself. Specific repayment plans had not been drawn up regarding this “house loan”, and even when it was sold, he had not completely paid off the loan from the company but rather had used the net cash proceeds to reduce a bank loan he had also been required to make in order to purchase a replacement residence. The schedule of the transactions described (Exhibit A-1) was provided to the Board by the agent for the appellant:

In addition to the above, an “on demand” promissory note dated December 31, 1974 from the appellant to Romy, in the amount of $108,000 bearing interest at 8% per annum, was entered and indexed as Exhibit A-2. Company financial statements covering the years in question were also made available.

In the notice of appeal, the taxpayer contended:

It is respectfully submitted that the advances received from Romy Ornamental Steel Limited by the taxpayer should not have been included in his income for the above noted three taxation years since these advances were received to enable the taxpayer to erect a dwelling house for his own occupation. These advances which were made to the taxpayer, as shareholder and officer of that company, should have been excluded from net income by virtue of paragraph 15(2)(a)(ii) of the Act.

The taxpayer did in fact use the proceeds of the loan to erect a dwelling which he occupied with his family. This home was located at 47 Old English Lane, Thornhill, Ontario.

The taxpayer did enter into a bona fide arrangement to repay the loan received from the corporation within a reasonable time. This repayment arrangement was documented and reflected in the corporation’s minutes of director’s meetings.

Subsequent events clearly indicate that the taxpayer had a bona fide intention to repay the loan received from the corporation and that this loan was not received as a disguised form of compensation.

In reply, it was the position of the respondent that:

— the amounts in question had not been repaid within one year;

— no arrangements, bona fide or otherwise, were made for repayment of the loan at the time the loan was made, or at any time, for repayment within a reasonable time.

The agent for the appellant attempted to distinguish between the two loans noted above and presented a detailed and lengthy argument which can be summarized in this way:

Factory Loan

1. It is our view that Section 15(2) has no application to include the amount advanced to build the factory in income. This was not a loan to Mr. Fontana qua shareholder but was a bona fide business transaction for the company. The fact that the transaction occurred with a party which happened to be a shareholder should not automatically result in the operation of Section 15(2).

2. The question that must be answered is whether this loan was made to Mr. Fontana solely because he was a shareholder or whether the company entered into this transaction in its ordinary course of business.

That is, was the company simply investing its excess funds as it would otherwise have done.

If it is an ordinary type of business transaction, Section 15 would not apply even though in the literal reading of the Section it would appear to apply since a shareholder is involved.

In the case of MNR vs. Pillsbury Holdings Limited 64 DTC 5184. Mr. Cattanach indicated the following on page 5187.

.. there can be no conferring of a benefit or advantage within the meaning of paragraph (c) where a corporation enters into a bona fide transaction with a shareholder. For example, Parliament could never have intended to tax the benefit or advantage that accrues to a customer of a corporation, merely because the particular customer happens to be a shareholder of the corporation, if that benefit or advantage is the benefit or advantage accruing to the shareholder in his capacity as a customer of the corporation. It could not be intended that the court go behind a bona fide business transaction between a corporation and a customer who happens to be a shareholder and try to evaluate the benefit or advantage accruing from the transaction to the customer.”

This same logic could be applied to Section 15(2). In this case the primary motive behind the transaction was to invest excess funds of the company. The fact that the loan was made to a shareholder was incidental to the main purpose of the loan.

Housing Loan

2. The only question that must be answered is whether the loan was made in accordance with the strict exempting provision of Section 15(2).

3. What must be answered on this loan is whether it complies with the phrase

“and bona fide arrangements were made at the time the loan was made for repayment thereof within a reasonable time, . . .”

(b) Although the initial $20,000 advance was received from the company in July, 1974 to purchase the land, the loan was not formalized until December, 1974.

The reason that the loan was not formalized at the time of the initial draw was that it was the intention that the initial draw would be paid from Mr. Fontana’s shareholder advance account. However once the draws exceeded the shareholder advance account the loan was formalized. This occurred on December 18, 1974.

At that time a “bona fide arrangement to repay the loan” was made. This bona fide arrangement was then reflected by appropriate journal entries at the end of the corporation’s fiscal year end on December 31, 1974.

It is submitted that even though none of the above repayment plans were documented, these repayment arrangements were nevertheless bona fide arrangements to repay the loan within a reasonable time.

The Income Tax Act, Canada does not specify that these arrangements must be documented in writing.

Mr Canale referred to certain related Interpretation Bulletins from Revenue Canada, and to the following cases:

MNR v Pillsbury Holdings Limited, [1964] CTC 294; 64 DTC 5184;

Massey-Ferguson Limited v The Queen, [1977] CTC 6; 77 DTC 5013;

John Altenhof v MNR, [1973] CTC 2303; 73 DTC 239;

Kenneth E Heal v MNR, [1980] CTC 2199; 80 DTC 1169.

The response of counsel for the respondent was simple and direct — the “factory loan” was just that — a “loan” — it was not a “payment” that fell within the ambit of paragraph 15(1 )(a) of the Income Tax Act. As a loan it must be dealt with according to the provisions for loans to shareholders under subsection 15(2) of the Act. It was not repaid within one year, and the “on demand” provision of the note (Exhibit A-2) is not equivalent to “within a reasonable period of time”. In fact, that type of note stipulates no specific repayment time which the Minister could even evaluate as reasonable or not.

With regard to the “shareholder’s advances”, it was evident from Exhibit A-1 (the schedule presented by the agent for the appellant) that the Minister had allowed the full extent of such advances as contra accounts against any loans from the company made by Mr Fontana, and assessed only the net increases each year. Further, it was noted by counsel that with regard to the “housing loan’, no evidence had been presented of any arrangements for repayment. The intention to repay is not equivalent to fixed arrangements for repayment, nor to repayment itself.

First, the Board deals with the effort of Mr Canale to set the “factory loan” up as something which could be described as a “bona fide business transaction”, thereby falling under paragraph 15(1 )(a) of the Act and escaping tax. Counsel for the respondent has touched on the significant point in that section. While it might well be argued that a “bona fide business arrangement” existed, at least to the degree that an interest-bearing promissory note was given (even though it was an “on demand” note), the provision of some $127,000 to the appellant must be examined to determine if it fills the requirements as a “payment” under paragraph 15(1 )(a) of the Act. As I would read it, within the context of the whole of section 15, a loan is dealt with separately. A loan is not a payment for goods or services, or for that matter for any purpose or even no purpose at all. There is even very little in the dictionary definition available on the word which would give comfort to the agent for the appellant, and indeed in “The LIVING WEBSTER Encyclopedic Dictionary of the English Language” (1973-1974 Edition) payment is described as “The act of paying; whatever is paid; recompense; requital; reward or punishment”. With regard to the verb “pay”, it is also interesting to note that the same source says: v./. To give money or goods that are due; to discharge a debt;” . . . (etc). I would be very surprised to find that the exact opposite interpretation “to incur a debt” could also be attributed to it, which is the essence of the argument on this point advanced by Mr Canale. I am persuaded by the argument of counsel for the respondent that the term “payment” in paragraph 15(1 )(a) does not include a loan made to a shareholder. That type of payment (to whatever degree it can be called a payment) is dealt with under subsection 15(2) of the Act, and is excluded from the provisions, either exempting or taxing, applicable under paragraph 15(1 )(a) of the Act. Since it was earlier noted that provision had been made in the reassessments at issue for the “shareholder’s advances”, any remaining portion of the so-called “factory loan” which forms part of the amounts at issue is therefore taxable and properly assessed. The question of any benefit or advantage to the appellant does not enter into a determination of this case, on this aspect of it.

Turning to the “house loan’, the Minister’s position is completely tenable. No evidence of arrangements was provided which would fulfill the requirements under subsection 15(2) for repayment.

In argument, Mr Canale quoted with approval a comment in Kenneth E Heal v MNR (supra) at 2201 and 1171 respectively:

The subsections of the Act (15(1) and 15(2) ) at issue here were obviously placed therein at least in part for the purpose of dissuading taxpayers from using the funds of corporations in which they were shareholders for purposes and in ways materially different from those to which such funds would be put by them in the regular business operations of the corporation.

I fail to see how that comment serves the appellant or provides confirmation of his position. While the corporation was certainly not prohibited from investing any surplus funds, lending money was not part of its ordinary business. It is not just the apparent opportunities for use of company funds by a shareholder provided for under section 15 of the Act that should be examined, it is also the clear constraints on such use, and the attendant taxation risks therein which must be carefully scrutinized.

I would also note that Mr Canale raised the point that in his view some relief should be available to the appellant by virtue of other sections of the Act which would recognize that some $8,840 of the amount at issue had been repaid during the year 1976 (see Exhibit A-1). My appreciation of the facts does not lead me as directly to the same conclusion, and I do not feel compelled to make any determination on the point. However, it is noted for the record and left to Mr Canale to pursue.

The appeal is dismissed.

Appeal dismissed.