Date: 20000314
Docket: 98-9199-IT-I
BETWEEN:
LOUTFEY KARAM,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for Judgment
Lamarre, J.T.C.C.
[1] These are appeals, filed under the informal procedure, from Notices of Determination of a Loss issued by the Minister of National Revenue ("Minister") under the Income Tax Act ("Act") in respect of the appellant's 1991, 1992, 1993 and 1994 taxation years. The Minister has determined the losses to be $114,745 in 1991, $98,560 in 1992, $46,667 in 1993 and $6,892 in 1994. In determining those losses, the Minister has disallowed interest expenses in the amounts of $16,823 for 1991, $20,174 for 1992, $10,449 for 1993 and $4,206 for 1994 on the basis that those amounts were not paid pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from a business or property. In calculating his losses, the appellant had initially claimed interest expenses in the amounts of $82,256 for 1991, $88,946 for 1992, $93,224 for 1993 and $71,947 for 1994. The appellant submits that the Minister arbitrarily disallowed a portion of the interest expenses in determining the business losses suffered during the years at issue. The appellant submits that the interest expenses disallowed can be ascertained and be proven to be interest paid pursuant to a legal obligation on money borrowed for the purpose of earning income from a property. According to the Notice of Appeal filed by the appellant, the interest expenses related to mortgages registered against a rental property and were not incurred to finance personal withdrawals as claimed by the respondent.
[2] The appellant also submits that the reassessment, notice of which is dated January 4, 1996, whereby the Minister reassessed the appellant's income tax for 1991 by adjusting the net business loss, is statute-barred. This argument is not pertinent as I have to come to a decision concerning the validity not of the reassessment but of the determination of losses, as required by the appellant pursuant to paragraph 152(1.1) of the Act.
Facts
[3] I heard the testimony of the appellant, of Mr. Ray Thomas, a certified management accountant (CMA) and a partner in the firm of Thomas McHugh Associates, and of Shaun Harkin, a technical advisor for Revenue Canada during the years at issue.
[4] The appellant testified that in 1968, he purchased a building located on Merivale Road in Ottawa ("Merivale property"), in which he operated a family grocery store ("Loui's Groceries"). He also rented space in that property to a restaurant.
[5] According to the appellant, he initially borrowed an amount from the Caisse Populaire Desjardins. The loan was secured by a first mortgage and was eventually transferred to the Royal Bank of Canada. No document was filed to that effect. On July 9, 1985, the appellant borrowed an additional amount of $80,000 from the Royal Bank of Canada. The amount was to be reimbursed over a four-year term. The appellant signed a promissory note in favour of the bank (Exhibit R-1) and the loan, according to his testimony, was also secured by a mortgage on his personal residence.
[6] On December 1, 1989, the appellant mortgaged the Merivale property to the Laurentian Bank of Canada in consideration of a loan of $550,000 (Exhibit A-2).
[7] The appellant also testified that he gave a private second mortgage on the Merivale property. There is no document to that effect. The appellant also filed in evidence two mortgage account statements from the Royal Bank of Canada showing the balance of the mortgage on his personal residence to be $151,235.77 for the period beginning May 1, 1990 and $166,129.74 for the period beginning September 1, 1990. No documents were presented to show any borrowings after that.
[8] The use of the borrowed amounts in 1985 and 1989 was not really explained. The appellant said that he sold his grocery business during the years at issue but had to repossess it within a short period of time. He said that he had to borrow money at that time to pay bills, to restock and to open a coffee shop, "the Canotek Café", that stayed open for only seven months in 1994.
[9] The appellant acknowledged that he operated the grocery store alone and that he withdrew cash every week from the cash register without necessarily reporting it in the business's books. He also said that he bought a BMW car in 1989 for a total sale price of $53,025, which was financed through the Royal Bank of Canada and the Bank of Nova Scotia. He apparently returned the car after having defaulted on his payments.
[10] The financial statements of Loui's Groceries for the years 1991, 1992 and 1994 together with a balance sheet extract from its general ledger for 1993 were filed in evidence. According to those documents, withdrawals in the amounts of $115,025, $151,284, $36,101.58 and $33,456 were made for the years 1991, 1992, 1993 and 1994 respectively. In a letter dated August 2, 1995 and signed by the accountant for the appellant, Mr. Ray Thomas, it was acknowledged that a portion of the withdrawals pertained to personal use. In another letter, dated November 20, 1995, addressed to Revenue Canada and signed by Mr. Thomas (Exhibit R-8), Mr. Thomas said the following:
Without doubt, some of the interest expense may be related to personal withdrawals. The large amounts in the drawing account are not cash withdrawals and that they probably reflect offsetting entries. We will attempt to determine the real explanation for it, but as you can appreciate, given the situation, it will be difficult.
[11] According to Mr. Thomas, the appellant's documents for 1991 and 1992 that were kept at his residence were destroyed by flood due to the failure of a sump pump motor. Mr. Thomas said that he only kept a copy of Loui's Groceries' financial statements. However, with a letter addressed to counsel for the respondent on January 20, 2000 (shortly before the hearing), Mr. Thomas enclosed a year-end adjusting entry from Loui's Groceries (Exhibit R-9) that he said he had just found in his files and which showed an entry of $49,164.68 in the "Drawings" account in the year 1992. Mr. Thomas said that according to Exhibit R-9, this entry was made in error thereby inflating the 1992 drawings account to the extent of $49,164.68. According to Mr. Thomas, this is further proof that the drawings account total was not $151,284 as shown in the 1992 financial statements. Mr. Thomas submits that it would not be fair to assume that such adjusting entries made at year-end represent drawings. In the words of Mr. Thomas, "since, Mr. Karam operated a proprietorship type business, the accountant has made an error by adjusting the drawings account" (see Exhibit R-10). In that same letter, Mr. Thomas claimed that for 1993 and 1994, the appellant's personal withdrawals were generally between $35,000 and $55,000 per year. He therefore proposed to adjust the drawings to the same amounts for 1991 and 1992 for the purposes of calculating the disallowed interest expenses.
[12] Mr. Thomas suggested that as the appellant was operating a proprietorship and was not a good records keeper, we should look at the whole capital account to determine whether the withdrawals were personal.
[13] The appellant submits that the loans were originally incurred for business purposes. Contrary to what he alleged in the Notice of Appeal, the appellant now claims that a portion of the loans was used for personal purposes. He considers that only $50,000 out of the total loans was borrowed for personal reasons.
[14] As one can readily appreciate, the evidence, both oral and documentary, is vague and incomplete, if not totally inaccurate and confusing. It is impossible for me to trace the use of the borrowed funds in any reasonable manner.
[15] Mr. Harkin, the auditor for Revenue Canada, testified
that the interest expenses were disallowed to the extent that
those expenses financed the unidentified withdrawals. There were
admissions on the part of the appellant during the audit that he
was living on credit. There were no internal controls over the
cash sales business operated by the appellant. In order to
calculate the
disallowed portion of interest expenses attributed to personal withdrawals, Mr. Harkin applied the "Kiss Formula" which was adopted by the Tax Review Board in Kiss v. M.N.R., 76 DTC 1093, a decision that was never appealed. This formula is applied to determine the personal portion of interest expenses when the withdrawals are greater than the net income from the business. It is expressed as follows:
[less net income from business]
or
Interest x withdrawals [plus net loss] = personal portion of interest
expenses loan balance expenses
[16] In the present case, the calculations with respect to the disallowed interest expenses are shown in Exhibit R-11 as follows:
Kiss Formula
Loutfey Karam
Expenses disallowed
|
1991 |
1992 |
1993 |
1994 |
|
|
Withdrawals |
$115,025 |
$151,284 |
$36,102 |
$33,456 |
|
Net loss |
(25,098) |
(32,782) |
(57,116) |
(10,970) |
|
$140,123 |
$184,066 |
$93,218 |
$44,426 |
|
|
Mortgages/loans |
685,141 |
811,553 |
831,678 |
759,999 |
|
Interest claimed |
82,256 |
88,946 |
93,224 |
71,947 |
|
Interest expenses disallowed |
$16,823 |
$20,174 |
$10,449 |
$4,206 |
|
Total expenses claimed |
$507,175 |
$498,757 |
$289,342 |
$197,873 |
|
Total expenses allowed |
490,352 |
478,583 |
278,893 |
193,667 |
|
Total expenses disallowed |
$16,823 |
$20,174 |
$10,449 |
$4,206 |
Interest expenses disallowed = (Withdrawals + Net loss) X Interest claimed
Mortgages/loans
For 1991 (140,123) * 82,256 = 16,822.75
685,141
For 1992 (184,066) * 88,946 = 20,173.59
811,553
For 1993 (93,218) * 93,224 = 10,448.94
831,553
For 1994 (44,426) * 71,947 = 4,205.69
759,999
Analysis
[17] This case involves determining whether or not the appellant was entitled to deduct the full amount of interest paid in respect of the borrowed funds. Subparagraph 20(1)(c)(i) of the Act deals with the deduction of interest, and it reads as follows:
SECTION 20: Deductions permitted in computing income from business
or property.
(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:
. . .
820(1)(c)w
(c) Interest – 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).
[18] In The Queen v. Bronfman Trust, 87 DTC 5059, Chief Justice Dickson of the Supreme Court of Canada stated at page 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 interest deduction provision requires not only a characterization of the use of borrowed funds, but also a characterization of "purpose". 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., 62 DTC 27 (T.A.B.) Consequently, the focus of the inquiry must be centered on the use to which the taxpayer put the borrowed funds.
[19] In Livingston International Inc. v. The Queen, 91 DTC 5066 (F.C.T.D.), Pinard J. summarized the proper interpretation to be given subparagraph 20(1)(c)(i) of the Act in the following terms at page 5069:
Proper interpretation of subparagraph 20(1)(c)(i) of the Act, therefore, requires that a taxpayer, before he or she can deduct interest expenses:
(a) trace the borrowed funds to an identifiable use which triggers the deduction; and
(b) generally demonstrate that the borrowed funds were used directly and immediately to earn income from a business or property;
the purpose of the provision being to "encourage the accumulation of capital which would produce taxable income".
[20] In Kiss, supra, Mr. Kiss sought to deduct interest on money allegedly borrowed for the purpose of providing working capital for the practice of his profession. Mr. Kiss's withdrawals were greater than his net income, and the Minister concluded that a portion of the bank loans negotiated by the appellant were for the purpose of financing his withdrawals and his cost of living expenses, and consequently that some portions of the interest payments were not amounts of interest paid on money borrowed for the purpose of earning income from Mr. Kiss's practice.
[21] Chairman Cardin, as he then was, made the remark that the onus of proving that the Minister's calculations (based on the "Kiss Formula") were wrong was on the appellant. He went on to say at pages 1094-1095:
. . . In the absence of any further evidence, or any suggestion on the part of the appellant as to an alternative method of making the necessary calculations, I can only conclude that the Minister's assumptions are correct and his method of calculating the allowable portion of the appellant's interest payments is logical and reasonable, based as it is on the difference between the appellant's drawings and his net professional income as disclosed on a cash basis in the financial statements submitted by the appellant with his income tax returns.
. . .
In this instance, the Board, on the basis of the evidence adduced, is justified in assuming that the appellant, having borrowed money for the alleged purpose of earning money from his practice, withdrew from his business some portion of that borrowed money for personal living expenses. The problem is to determine what portions of the appellant's loans were used to earn income and what portions were used for personal living expenses, so that the non-deductible portions of the interest payments on the loans can be determined.
[Dismissal]
In my opinion, the Minister's approach to the problem is reasonable and logical.
[22] In the present case, the appellant has recognized that he did use part of his borrowings for personal purposes. This is also evidenced by the financial statements in which the increase in the withdrawals is not counterbalanced by an increase in the value of the assets of the business. For example, according to the 1991, 1992 and 1993 financial statements (Exhibits R-3, R-4 and R-5), the mortgage payable went up from $685,141 in 1991 to $811,553 in 1992 and decreased slightly to $794,564.79 in 1993 whereas the inventory and the value of total assets went down. The withdrawals, however, rose from $115,025 in 1991 to $151,284 in 1992. They were lower in 1993 and 1994.
[23] The appellant has incurred business losses for all those years. His wife did not work and he has admitted that he was living on credit.
[24] The appellant submits that there was an error at the audit stage and that the withdrawals shown in the book entries were higher than the actual amounts. The appellant also suggests that only a small portion of the borrowed funds was used for personal purposes. He also claims that the Minister did not show clearly which expenses were disallowed. As Chairman Cardin said in Kiss, supra, the appellant might be partly justified in his claims, however the onus of proving that the Minister's calculations are wrong is on him. Here the evidence given by the appellant is far from being sufficient to discharge the onus to trace the borrowed funds to an identifiable use which triggers the deduction of interest.
[25] In fact, the financial statements disclose that the borrowings were not done to increase the capital in the business so as to produce taxable income.
[26] In the absence of any reasonable alternative method of making the calculations of the non-deductible portion of the interest expenses, I can only conclude, as did Chairman Cardin, that the Minister's method of calculating the allowable portion of the appellant's interest payments is logical and reasonable.
[27] Furthermore, the appellant has not convinced me that the figures taken into account by the Minister with respect to the withdrawals and the borrowed funds in calculating the non-deductible portion of the interest expenses were incorrect.
[28] The appeals are therefore dismissed.
Signed at Ottawa, Canada, this 14th day of March 2000.
"Lucie Lamarre"
J.T.C.C.