Date: 19980828
Docket: 96-2868-IT-I
BETWEEN:
JOSEPH H. KRONSTAL,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for Judgment
O'Connor, J.T.C.C.
[1] These appeals were heard at Yellowknife, Northwest Territories on August 5, 1998.
[2] The only witness heard was the Appellant himself.
Issues
[3] The issues are:
(a) whether the Appellant was entitled to deduct interest expenses in the amount of $1,660.73, $1,456.29 and $1,254.03 for the 1992, 1993 and 1994 taxation years respectively in respect of monies borrowed on the Appellant's personal line of credit and advanced to two corporations of which the Appellant was a shareholder;
(b) whether the Appellant was entitled to Allowable Business Investment Losses ("ABIL(s)") in the amounts of $4,391, $9,300 and $16,548.93 in the 1992, 1993, and 1994 taxation years in respect of monies advanced to the said two corporations.
Facts
[4] I find the principal facts to be as follows:
1. The Appellant, prior to 1987, was an advisor to the Northwest Territories Development Association and in that role advanced as one of his concerns that it would be beneficial to the community if a local dairy operation could be established. To that end he involved 48 investors. An 80 cow operation was contemplated. After much investment of time and money this first venture, carried on through a corporation called Agriborealis Ltd. ("Agriborealis"), failed and went into receivership in 1987 mainly because of difficulties in complying with dairy operation regulations based upon standards used in Alberta. In 1988 the Town of Yellowknife ("Yellowknife") purchased from the Trustee in Bankruptcy of Agriborealis the land which had been set aside for the dairy operation.
2. Around the same time the Appellant was hired by Yellowknife in its financial department. He was still interested in a dairy project. He arranged for the incorporation of Tuaro Dairy Corporation Ltd. ("Tuaro") in 1990 and West Arctic Six Ltd. ("West") in 1991. Both are Canadian controlled private corporations and qualify as small business corporations. West was originally planned as a dairy equipment rental operation. It purchased the equipment and leased same to Tuaro. A lease was executed and two lease payments were made prior to the events described below.
3. The Appellant was a substantial (but not majority) shareholder in Tuaro and West and at arm's length with both corporations. Several other investors were also involved in both.
4. At least three attempts were made to obtain financing for the dairy operation. These did not succeed and it was only in 1995 that The Canadian Imperial Bank of Commerce ("CIBC") agreed to finance, subject to certain conditions including security on the dairy equipment and Tuaro being free of debt. Thus, the lease between Tuaro and West of the dairy equipment was terminated and West conveyed the equipment to Tuaro in exchange for shares in Tuaro. The operation was to be carried on on the property which Yellowknife had leased to Tuaro for an initial five-year term with rights to renew and rights to purchase in favour of Tuaro.
5. The operation took time to get going, owing to various problems including delays in product testing and ferry problems bringing in cows. The operation finally commenced in May, 1996. The June 12, 1996 edition of the "Yellowknifer" contained an article pronouncing that the "first batch of locally produced milk in years is now on the shelves" and confirmed that Tuaro began its operation from its plant approximately two weeks prior to June 12. This article went on to describe the operation and the new efficient equipment which had been installed.
[5] Before describing the investments made by the Appellant in the corporations, it should be noted that, for various reasons, Tuaro went into receivership in March of 1998.
[6] The Appellant invested in the corporations, both by acquiring shares and advancing loans. In these appeals the interest expenses and the ABILs claimed relate only to the monies advanced by way of loans. Complete details of the interest expenses and ABILs claimed are provided in Schedules 1, 2 and 3 of the Reply to the Notice of Appeal. In summary, the Appellant made the following loans to Tuaro and West, namely: $5,855 in 1992 (ABIL $5,855 x 3/4 = $4,391); $12,400 in 1993 (ABIL $12,400 x 3/4 = $9,300); and $37,065.24 in 1994 (ABIL $37,065.24 x 3/4 = $27,798.93). The Minister disallowed the ABILs claimed in 1992 and 1993 and, in 1994, allowed $15,000 of the $37,065.24 claimed. Thus, with respect to 1994 the ABIL in dispute is $16,548.93 ($27,798.93 - 3/4 of $15,000 or $11,250). The $15,000 allowed related to a settlement regarding Agriborealis which is not of concern in this appeal.
[7] The Appellant testified he never expected to be repaid the advances. They were made to start up the corporations with the expectation that in the future the corporations would be profitable and pay dividends.
[8] The total interest expenses claimed by the Appellant were as follows:
1992 $3,276.29
1993 $2,419.44
1994 $3,172.74
Of these amounts the Minister allowed the following, namely
1992 $1,615.56
1993 $963.15
1994 $1,918.71
thereby leaving in dispute the following amounts:
1992 $1,660.73
1993 $1,456.29
1994 $1,254.03
In a letter accompanying the reassessment the Minister stated that the reason for disallowing the interest expenses in dispute was "the purpose of the funds advanced by the CIBC Personal Line of Credit was not determined by the supporting documentation submitted". The Appellant testified that the monies advanced to him on his personal line of credit were in turn advanced to the corporations at the same interest rate that the CIBC charged the Appellant.
Submissions of the Appellant
(Hereafter, all provisions mentioned are references to the Income Tax Act ("Act")).
[9] The Appellant submits with respect to the interest expenses that all of the interest he claimed, including the amounts in dispute, were in respect of advances made to the corporations for the purposes of earning income from a business or property. The Minister has accepted certain amounts claimed as interest but has disallowed the portions thereof which relate to "personal line of credit". The Appellant submits that his testimony is clear that, notwithstanding reference to the personal line of credit, the monies he borrowed in that account were advanced to the corporations in the same way as the other amounts advanced the interest on which the Minister has allowed. The Appellant refers to Revenue Canada's Interpretation Bulletin IT-445 which he submits supports his claim for the interest expense deductions. Admittedly, the Appellant borrowed monies from CIBC at a certain interest rate and advanced those monies to the corporations at the same interest rate. This, however, in the Appellant's view, does not negate the fact that the monies were advanced for the purpose of earning income from a business or property.
[10] With respect to the ABILs, the Appellant refers to Revenue Canada's Interpretation Bulletin IT-484R2 in support of his claim. He refers to his testimony that he realized he never would recover the amounts advanced. In his 1992, 1993 and 1994 returns he declared the advances as bad debts and claimed the ABILs related thereto. Further he advanced the monies to get the businesses going and as start up, not expecting to be repaid those monies, but once the corporations were operating profitably they would provide an income stream to him by way of dividends.
Submissions of the Respondent
[11] With respect to the interest expenses the Respondent submits that the Appellant has not proven that he acquired a debt for the purposes of gaining or producing income from a business or property. Counsel for the Respondent points out that the interest charged by the Appellant on the loans to the corporations was the same as the interest that he had to pay to the CIBC and deduces from that that the monies were not loaned for the purposes of gaining or producing income from a business or property.
[12] With respect to the ABILs, counsel contends that the Appellant has not proven that he incurred the losses within the meaning of paragraph 39(1)(c) of the Act. More specifically, that the Appellant did not incur a capital loss from a disposition to which subsection 50(1) of the Act applies of a debt because the Appellant did not make a disposition of the debt. Counsel concludes that the Appellant is not entitled to the ABILs claimed because he does not meet the conditions established in subsection 50(1), paragraph 39(1)(c) and 40(2)(g) of the Act.
Analysis and Decision
[13] The relevant provisions of the Act, so far as material, are 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 on the method regularly followed by the taxpayer in computing the taxpayer's 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 ...
39 (1) For the purposes of this Act,
...
(c) a taxpayer's business investment loss for a taxation year from the disposition of any property is the amount, if any, by which the taxpayer's capital loss for the year from a disposition after 1977
(i) to which subsection 50(1) applies, ...
of any property that is
(iii) a share of the capital stock of a small business corporation, or
(iv) a debt owing to the taxpayer by a Canadian-controlled private corporation ... that is
(A) a small business corporation, ...
exceeds the total of ...
40 (2) Notwithstanding subsection (1),
...
(g) a taxpayer's loss, if any, from the disposition of a property, to the extent that it is
...
(ii) a loss from the disposition of a debt or other right to receive an amount, unless the debt or right, as the case may be, was acquired by the taxpayer for the purpose of gaining or producing income from a business or property (other than exempt income) or as consideration for the disposition of capital property to a person with whom the taxpayer was dealing at arm's length, ...
is nil; ...
50 (1) For the purposes of this subdivision, where
(a) a debt owing to a taxpayer at the end of a taxation year ... is established by the taxpayer to have become a bad debt in the year, or
(b) a share ...
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 for proceeds equal to nil and to have reacquired it immediately thereafter at a cost equal to nil.
[14] The following extracts from the relevant Interpretation Bulletins are helpful.
IT-445
General Position
3. Interest expense on money borrowed to be loaned at a reasonable rate of interest, or to honour a guarantee which had been given for adequate consideration, is generally deductible. However, interest expense incurred on borrowed money is generally not deductible in whole or in part when that money
(a) is loaned interest-free or at less than a reasonable rate of interest. ...
6. A loan will not be considered to be made at a reasonable rate of interest where a shareholder borrows money at interest and loans that money to a corporation of which he is a shareholder, or to its subsidiary controlled corporation (subsidiary), at a lesser rate of interest than that at which the shareholder borrows the money.
Exception to the General Position
7. Notwithstanding the comments in 3, 5 and 6 above, the Department will generally permit a deduction for the full interest expense incurred when a taxpayer borrows money at interest to be loaned to a Canadian corporation of which he is a shareholder ... at less than a reasonable rate of interest, (or at no interest), if the following conditions are met:
(a) the proceeds of the loan are used by that corporation in its own operations to produce income from business or property which will be subject to Part I tax in Canada, or ...
(b) the corporation has made every effort to borrow the necessary funds through the usual commercial money markets but cannot obtain financing, without the guarantee of the shareholder, at interest rates at which the shareholder could borrow, and
(c) the loan from the shareholder to the corporation at less than a reasonable rate of interest (or at no interest) does not result in any undue tax advantage being conferred on either the shareholder or the corporation. ...
...
IT-239R2
5. Similarly, money which had been loaned at a reasonable rate of interest generally constitutes a debt acquired for the purpose of gaining or producing income, and any capital loss which arises because it has become uncollectible is generally not deemed to be nil by virtue of subparagraph 40(2)(g)(ii). It is the Department's view that money has not been loaned at a reasonable rate of interest where a taxpayer borrows money at interest and loans that money to a corporation of which he is a shareholder, or to its subsidiary controlled corporation ("subsidiary"), at a lesser rate of interest than that at which the taxpayer borrows the money.
...
IT-484R2
Summary
A business investment loss is basically a capital loss from a disposition to which subsection 50(1) applies, or to an arm's length person, of shares or debt of a small business corporation. Three-quarters of this loss is an allowable business investment loss.
Unlike ordinary allowable capital losses, an allowable business investment loss for a taxation year may be deducted from all sources of income for that year. Generally, an allowable business investment loss that cannot be deducted in the year it arises is treated as a non-capital loss which may be carried back three years and forward seven years to be deducted in calculating taxable income of such other years. Any such loss that is not deducted by the end of the seven-year carry-forward period is then treated as a net capital loss so that it can be carried forward indefinitely to be deducted against taxable capital gains.
Ordinary allowable capital losses for a taxation year may be deducted only from taxable capital gains realized in the year. If the allowable capital losses exceed the taxable capital gains, the difference is a net capital loss which may be carried back three years and forward indefinitely to be deducted only against taxable capital gains.
The purpose of the rules relating to the business investment loss is to encourage investment in small business corporations by giving such losses more generous tax treatment than that available for ordinary capital losses.
This bulletin discusses the various provisions of the Act relevant to determining what constitutes a taxpayer's allowable business investment loss for a taxation year and the deductibility of such a loss.
Discussion and Interpretation
1. An "allowable business investment loss" is defined in paragraph 38(c) as 3/4 of a "business investment loss" defined in paragraph 39(1)(c). To qualify as a business investment loss, an amount must first be a capital loss. Thus when a transaction does not give rise to a capital loss, or when a capital loss is deemed to be nil (e.g., under paragraph 40(2)(g)), no business investment loss can result.
Although a business investment loss for a year must first qualify as a capital loss, a taxpayer does not have the option of treating it as a capital loss for the year rather than a business investment loss.
...
3. A taxpayer's business investment loss may arise from the disposition of:
(a) a share of a corporation that is a small business corporation, or
(b) a debt owing to the taxpayer (except as discussed in paragraph 5 below) by a Canadian-controlled private corporation.
For a loss on the disposition of such property to qualify as a business investment loss, the disposition must be to an arm's length person or be deemed to have occurred under subsection 50(1) (see paragraph 6 below). ...
...
6. Subsection 50(1) deems a taxpayer to have disposed of a debt or a share of a corporation at the end of a taxation year for nil proceeds and to have reaquired it immediately thereafter at a cost of nil if:
in the case of a debt (other than a debt from the sale of personal use property), the debt is owing to the taxpayer at the end of the taxation year and it is established by the taxpayer to have become a bad debt in the year; and ...
[15] As to the amounts of interest disallowed the Minister has only disallowed the portions of the interest claimed which relate to the personal line of credit. The Appellant testified (the Appellant's credibility is accepted without reserve) that although the amounts were borrowed from CIBC on his personal line of credit, the total of those amounts nevertheless went into the corporations and the amounts advanced were for the purpose of earning income from a business or property. I do not believe that his interest costs of borrowing the money from CIBC being equal to the interest cost he was charging to the corporations negates the Appellant's intention to earn income as a result of the advances. Reference is made to the Interpretation Bulletins (ITBs) referred to above. The rate charged to the corporations was a reasonable rate and the ITBs support the Appellant's position. In conclusion, I have no doubt that the amounts advanced to the corporations (although representing monies advanced by CIBC on the Appellant's personal line of credit) were advanced to the corporations for purposes of earning income and were properly deductible.
[16] As to the ABILs claimed, the Appellant did not convey the debts to a third party for nil or minimal consideration nor did he forgive the debt or exhaust all legal remedies to get paid. The Appellant's case would have been stronger had any of those events occurred. Nevertheless, I am satisfied that the Appellant, as required by subsection 50(1), has established the debts to have become bad in the years in question. In my opinion there has been a deemed disposition of the debt as the Appellant's uncontroverted testimony establishes that the debts were bad. He knew he could not recover the advances. The Appellant treated them as bad and so filed his income tax returns. His testimony was that he never expected the money back (after the initial attempts at financing failed). Consequently the debts have been proven to be bad. As the Appellant explained, he advanced these monies to keep the businesses alive expecting future income flows through dividends. The monies advanced were for start-up costs and to create and keep the business going to a point where it could earn a profit. As ITB 484R2 states "The purpose of the rules relating to the business investment loss is to encourage investment in small business corporations by giving such losses more generous tax treatment than that available for ordinary capital losses". If that is the purpose, the Appellant's situation cries out for the application of the rules.
[17] Further, I do not believe that paragraph 40(2)(g)(ii) is applicable to render the loss nil. In my opinion, the Appellant has proved that the advances were made for the purpose of earning income from a business or property; and further there was no non-arm's length element involved.
[18] I believe the following statement of Rip, J. in Business Art Inc. v. M.N.R., 86 DTC 1842, at 1848, applies a fortiori to these appeals:
However, even if no interest was chargeable I do not believe that would be fatal to the appellant's alternate submission. The fact that there may have been no interest attached to the debts in question is not relevant in deciding whether they were acquired for the purpose of gaining or producing income. See The Queen v. Lalande and Watelle, 84 DTC 6159 at page 6164. It is not uncommon for a shareholder to lend money without interest and without security to the corporation since he anticipates that the loans will assist the corporation to earn income and to pay him income by way of dividends; the loan is made for the purpose of earning income from a property. Although the shareholder is a creditor of the corporation when he advances money to the corporation the shareholder does not see his advance of money to the corporation and his subscription for shares of the corporation as separate investments in two watertight compartments; rather he sees his money entering two compartments which open up into a single compartment for the use of the corporation. Purchasing shares and advancing money to a corporation are two ways of making an investment in the corporation. This is a sensible interpretation.
Similarly a shareholder of a corporation who may have incorporated a corporation for the purpose of acquiring product at a low cost and so reduce its own costs may advance money without interest to the corporation to enable the corporation to operate as intended; in this example even if the shareholder is not making loans for the purpose of producing income from its business, by having reduced costs, the loan is being made to earn income form property, that is, to receive dividends on the shares it owns in the corporation. It is not unusual for a person to invest in a corporation by subscribing for share capital and lending money without interest; as far as he is concerned the shares and his loans constitute a single investment and if later on, he is called on to advance further funds without interest he is only increasing his investment. I cannot subscribe to the theory that in such an example the non-interest bearing loans were not incurred for the purpose of earning income from property; if the loans were not advanced the corporation may have become bankrupt and the shares may have become worthless. Clearly the loans were made to earn income from property, that is, to place the corporation in a position where it will be successful and pay dividends.
[18] I note that no claim for loss on the investment of monies to acquire shares of the corporations has been claimed by the Appellant. His claims in this regard relate only to the loans that went bad. One may deduce from that that the Appellant did not consider he had a loss on the shares as he expected the corporations to operate and generate revenues but that he had a loss on the loans knowing he could not recover them.
[19] Perhaps these appeals would not have proceeded to trial had the Minister realized prior to trial that certain of the key assumptions in the Reply would be refuted. I refer specifically to the assumptions that the Appellant was a majority shareholder of Tuaro, was not dealing at arm's length with Tuaro or West and that Tuaro and West did not commence operations.
[19] By way of obiter, I add that, if as the Appellant testified, Tuaro went into receivership in 1998 and the appellant still owned shares at that time, there would presumably be a loss on the shares in 1998. Moreover, if I am wrong in concluding that losses on the loans were incurred in 1992, 1993 and 1994, such losses presumably would clearly chrystallize in 1998 enabling the Appellant to claim them in that year and/or to carry them back three years or forward as provided in section 111 of the Act.
[20] In conclusion, for all of the above reasons, the appeals are allowed and the matter is referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the Appellant was entitled to deduct the interest expenses and ABILs claimed in the 1992, 1993 and 1994 years.
Signed at Ottawa, Canada this 28th day of August 1998.
"T.P. O'Connor"
J.T.C.C.