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Docket: 2001-199(IT)G |
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BETWEEN: |
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BANNER PHARMACAPS NRO LTD., |
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Appellant, |
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and |
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HER MAJESTY THE QUEEN, |
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Respondent. |
____________________________________________________________________
Appeal heard on April 11, 2002, at Calgary, Alberta,
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Before: The Honourable Judge M.A. Mogan |
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Appearances: |
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Counsel for the Appellant: |
Michel Bourque and Curtis Stewart |
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Counsel for the Respondent: |
Julia S. Parker |
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JUDGMENT
The appeal from the assessment of tax made under the Income Tax Act for the 1996 taxation year is dismissed, with costs.
Signed at Ottawa, Canada, this 26th day of February, 2003.
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"M.A. Mogan" |
J.T.C.C.
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Citation: 2003TCC82 |
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Date: 20030226 |
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Docket: 2001-199(IT)G |
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BETWEEN: |
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BANNER PHARMACAPS NRO LTD., |
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Appellant, |
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and |
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HER MAJESTY THE QUEEN, |
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Respondent. |
REASONS FOR JUDGMENT
Mogan J.
[1] The Appellant was incorporated under the laws of the Province of Alberta on or about January 2, 1996. The Appellant's corporate T2 income tax return for 1996 (Exhibit 22) shows its first taxation year as running from February 14 to December 31. The reason for the Appellant's choice of February 14 as the commencement of its first fiscal period will be apparent from the facts set out below. The principal issue in this appeal is whether the Appellant was a "non-resident-owned investment corporation" (within the meaning of section 133 of the Income Tax Act) in its 1996 taxation year. A non-resident-owned investment corporation is commonly referred to as an "NRO" in all Canadian tax literature, and I will use that abbreviation herein. The second issue is whether the Appellant received in 1996 or was required to include in its 1996 income a particular dividend in the amount of $5,647,775. The only taxation year under appeal is 1996.
The Facts
[2] Banner Pharmacaps Inc. (hereafter "Banner USA") is incorporated under the laws of Delaware, one of the states in the U.S.A. Banner USA carries on the business of manufacturing soft gelatin capsules in bulk for the pharmaceutical and nutritional industries. Banner Gelatin Products (Canada) Ltd. (hereafter "Banner Canada") is incorporated under the Canada Business Corporations Act and carries on business at Olds, Alberta about 100 kilometres north of Calgary. Banner Canada carries on the same kind of business as Banner USA. Prior to 1996, all the issued shares of Banner Canada were owned by Banner USA. At all relevant times, all of the issued shares of Banner USA were owned by Sobel Inc. (an American corporation) and all of the issued shares of Sobel Inc. were owned by Sobel NV (a Netherlands corporation).
[3] Banner Canada has carried on business since around 1982. By the end of 1995, Banner Canada had retained earnings of approximately $5.6 million. In 1995, a decision was made to insert an NRO between Banner Canada and Banner USA. As stated above, the Appellant was incorporated in January 1996. The Appellant was the intended NRO. The theory of an NRO was explained as follows in a letter dated September 7, 1994 (Exhibit 20) from BDO Dunwoody, the outside auditors of Banner Canada:
(i) Banner Canada controlled by a non-resident was taxed in Canada at corporate rates of 45-50%.
(ii) Interest paid on borrowed money by Banner Canada to an NRO would be deductible in computing income and would result in an outright saving at general corporate rates (45-50%) in the hands of Banner Canada.
(iii) Interest received by an NRO on money loaned to Banner Canada would be taxed in Canada at a rate of only 25%.
(iv) A dividend paid by an NRO to its non-resident parent would trigger an "allowable refund" to the NRO. In general terms, an allowable refund is 25% of the amount of the dividend paid; and such refund is remitted to the NRO by Revenue Canada. In other words, if the amount of interest received by an NRO from Banner Canada were flowed through to its non-resident parent by way of a dividend, that dividend would trigger an allowable refund to the NRO from Revenue Canada equal in amount to the tax which the NRO was liable to pay on receipt of the interest from Banner Canada.
(v) There would be withholding tax in Canada of about 10% (subject to the terms of the Canada-U.S. Income Tax Convention) on the dividend paid by the NRO to its non-resident parent.
[4] The concept of an NRO has been part of the income tax law in Canada for more than 50 years. Apparently, it was first introduced as a vehicle to encourage non-residents to invest capital in Canada. Attitudes change, however, and the federal budget of February 2000 announced the phasing out of all NROs.
[5] By an agreement in writing made as of February 14, 1996 (Exhibit 1), Banner USA agreed to sell to the Appellant all of the issued shares of Banner Canada at a price of $8,700,000. The Appellant satisfied the purchase price by delivering to Banner USA 2,979,737 fully paid common voting shares of the Appellant. The balance sheet included in the Appellant's 1996 income tax return (Exhibit 22) shows that its share capital at December 31, 1996 was $2,979,737. Exhibits 2, 3, 4, 5, 6, 7 and 8 are corporate documents confirming that on February 14, 1996, Banner Canada became a wholly-owned subsidiary of the Appellant, and the Appellant became a wholly-owned subsidiary of Banner USA.
[6] On February 15, 1996, the day following the Appellant's acquisition of Banner Canada, there were two significant commercial transactions. First, Banner Canada reduced the stated capital of its shares by the amount $852,225. And second, Banner Canada declared a dividend in the amount $5,647,775. The aggregate of those two amounts is $6,500,000. Exhibit 10 is the resolution of the sole shareholder of Banner Canada reducing the stated capital and declaring the dividend. Set out below are the operative parts of the shareholder resolution:
1. RESOLVED THAT the Corporation reduce the stated capital of its shares by the amount of $852,225 by distributing $852,225 to the holders of record of its shares on the date hereof, payment of such distribution to be made by the issuance of a demand promissory note which shall bear interest until paid at the prime rate of the Toronto-Dominion Bank plus 1% per annum;
2. RESOLVED THAT there is hereby declared on the shares of the Corporation a dividend to be payable to the holders of record of the shares of the Corporation on the date hereof, such dividend to be in the aggregate amount of $5,647,775 and to be payable by the Corporation by the issuance of a demand promissory note which shall bear interest until paid at the prime rate of The Toronto-Dominion Bank plus 1% per annum;
3. RESOLVED THAT the foregoing resolutions are passed on the basis that the undersigned is reasonably satisfied that after giving effect to each of the foregoing resolutions the Corporation will be able to pay its liabilities as they come due and the net realizable value of the assets of the Corporation will exceed the liabilities of the Corporation and the stated capital of all of the shares of the Corporation; and
4. RESOLVED THAT in connection with the foregoing transactions, any officer of the Corporation is authorized to take such action and to execute and deliver for and on behalf of the Corporation (and under corporate seal or otherwise) such agreements, documents and instruments as such officer deems appropriate to give effect to the foregoing resolutions.
[7] Exhibit 12 is a copy of the demand promissory note dated February 15, 1996 in the amount of $852,225 issued by Banner Canada with the following operative words:
FOR VALUE RECEIVED, Banner Gelatin Products (Canada) Ltd. (the "Corporation") hereby promises to pay on demand to Banner Pharmacaps NRO Ltd. the principal amount of Eight Hundred and Fifty-Two Thousand Two Hundred Twenty-Five Dollars ($852,225) and to pay interest thereon at a rate equal to the prime rate announced from time to time by the Toronto Dominion Bank plus one percent (1%) per annum with interest to be payable annually on the last business day of each year. Such indebtedness shall be prepayable by the Corporation at any time without premium.
Exhibit 13 is a copy of the demand promissory note dated February 15, 1996 in the amount of $5,647,775 issued by Banner Canada with the following operative words:
FOR VALUE RECEIVED, Banner Gelatin Products (Canada) Ltd. (the "Corporation") hereby promises to pay on demand to Banner Pharmacaps NRO Ltd. the principal amount of Five Million Six Hundred Forty-Seven Thousand Seven Hundred Seventy-Five Dollars ($5,647,775) and to pay interest thereon at a rate equal to the prime rate announced from time to time by the Toronto Dominion Bank plus one percent (1%) per annum with interest to be payable annually on the last business day of each year. Such indebtedness shall be prepayable by the Corporation at any time without premium.
[8] Exhibit 15 is a copy of the letter dated March 22, 1996 from BDO Dunwoody to Revenue Canada with respect to the Appellant electing to be an NRO. The first paragraph of the letter states:
Re: Banner Pharmacaps NRO Ltd. ("Corporation")
Pursuant to the provisions of Section 500 of the Income Tax Regulations ("the Regulations") to the Canadian Income Tax Act ("the Act"), this letter is to advise you that the Corporation elects to be taxed under Section 133 as a Non-Resident Owned Investment Corporation ("NRO").
Exhibit 16 is a copy of the letter dated July 16, 1996 from Revenue Canada to the Appellant confirming that the election to be an NRO was valid. Because it is short, I will set out all of Exhibit 16:
RE: Election to be Taxed as a Non-Resident-Owned Investment Corporation (Section 133 of the Income Tax Act)
Please be advised that based on a review of the documentation submitted in support of the above election, the election is considered to be valid.
If you have any questions about this letter, please contact Joan Hampl at 691-8674.
"Signature"
Exhibits 17 and 18 are letters dated June 12 and July 9, 1996, respectively, between Revenue Canada and the Appellant with respect to further information requested to complete the Appellant's election to be an NRO.
[9] The Appellant's financial statements for the year ended December 31, 1996 are Exhibit 27 and they disclose the following information:
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(i) Revenue - Dividends |
$5,647,775 |
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(ii) Retained earnings |
5,647,775 |
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(iii) Assets- Loan receivable |
6,500,000 |
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(iv) Assets - Investment |
2,127,512 |
The revenue and retained earnings are the precise same amount as the dividend declared on February 15, 1996 by Banner Canada. The loan receivable is the aggregate of the two demand promissory notes described in paragraph 7 above. And the investment of $2,127,512 is the original share capital of Banner Canada ($2,979,737) less the reduction in stated capital ($852,225) effected on February 15, 1996.
[10] Mr. Reynolds, the first witness for the Appellant, explained Exhibits 28, 29 and 30. Exhibit 28 is the general ledger postings for Banner Canada which showed the reduction of the stated capital ($852,225), the payment of the dividend ($5,647,775), and the issuing of the promissory notes in the aggregate amount of $6,500,000. Exhibit 29 comprises seven pages of the Appellant's accounting records. The first page of Exhibit 29 shows that the Appellant first accrued interest receivable with respect to the promissory notes of $6,500,000 in October 1996 when interest of $269,126 was recorded to the end of September. Thereafter, interest was accrued each month as follows:
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October |
$31,431.51 |
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November |
29,071.92 |
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December |
28,671.23 |
[11] At December 31, 1996, the Appellant had accrued interest receivable of $358,301.38. The fourth page of Exhibit 29 shows that the Appellant accrued interest of $28,671.23 in each of January and February 1997 but the aggregate of those two amounts ($57,342.46) was reversed in March, probably around the time when BDO Dunwoody began to question the NRO status of the Appellant. That same fourth page of Exhibit 29 shows that in May 1997, the Appellant reversed the entire amount of interest receivable ($358,301.38) which had been accrued to December 31, 1996.
[12] Exhibit 30 comprises six pages of accounting records for Banner Canada. In effect, Exhibit 30 shows the other side of the transactions in Exhibit 29. Whereas in Exhibit 29 the Appellant was accruing interest receivable on the promissory noted in late 1996 and then reversing that interest receivable in May 1997, Banner Canada in Exhibit 30 was accruing interest payable on the promissory notes in late 1996 and then reversing that interest payable in May 1997. In particular, the sixth page of Exhibit 30 shows the journal entry where interest payable of $358,301.38 is reversed in May 1997.
[13] The Appellant's financial statements for the year ending December 31, 1996 (Exhibit 27) and the accounting records of the Appellant and Banner Canada in Exhibits 28, 29 and 30 prove that Banner Canada's reduction of stated capital ($852,225) and declaration of dividend ($5,647,775) were real transactions. Those transactions were accepted by the Appellant and Banner Canada and recorded in their respective books and records.
[14] In early 1997, the person at BDO Dunwoody (Mr. Butalia) who was advising Banner Canada and the Appellant became concerned that the Appellant would not qualify as an NRO. Specifically, Mr. Butalia was involved in negotiations with Revenue Canada on behalf of another client; and Revenue Canada was taking the position (i) that the provision of even one loan by the NRO would be considered as the business of making loans; and (ii) that the loan-making corporation would be denied NRO status. Mr. Butalia communicated his concerns to the Banner group of companies by memorandum dated April 25, 1997 (Exhibit 21). In that memorandum, Mr. Butalia recommended that the Appellant not be used as an NRO.
[15] Mr. Butalia's recommendation was accepted and followed by the Banner group of companies. When the Appellant filed its 1996 income tax return (Exhibit 22) in May 1997, it filed as an ordinary corporation and not as an NRO. It was in the same month (May 1997) that the Appellant reversed its interest receivable with respect to 1996, and Banner Canada reversed its interest payable with respect to 1996 as described in paragraphs 11 and 12 above. When filing as an ordinary corporation (not as an NRO), the Appellant relied on section 112 of the Act to deduct in computing taxable income the amount of $5,647,775 which it had included in income as a dividend received from Banner Canada. Accordingly, the Appellant reported nil taxable income in its 1996 income tax return.
[16] Although the Appellant filed its 1996 income tax return as an ordinary corporation and not as an NRO, the Minister of National Revenue issued a Notice of Reassessment dated February 7, 2000 (Exhibit 23) adopting the position that the Appellant was an NRO with respect to its 1996 taxation year. The Appellant objected to the Reassessment but the Minister confirmed his position (Exhibit 25) that the Appellant was an NRO for 1996. The consequences of the reassessment are significant to the Appellant because, under subsection 133(2) of the Act, an NRO may not deduct in computing taxable income any amount received as a dividend from a Canadian corporation. An NRO does not enjoy the benefit of tax-free intercorporate dividends under section 112 of the Act. The Notice of Reassessment showed Part I tax payable in the amount of $1,411,943.75.
Analysis
[17] As stated above, the principal issue in this case is whether the Appellant was an NRO in its 1996 taxation year. An NRO is defined as follows in subsection 133(8):
133(8) In this section,
"non-resident-owned investment corporation" means a corporation incorporated in Canada that, throughout the whole of the period commencing on the later of June 18, 1971 and the day on which it was incorporated and ending on the last day of the taxation year in respect of which the expression is being applied, complied with the following conditions:
(a) all of its issued shares and all of its bonds, debentures and other funded indebtedness were
(i) beneficially owned by non-resident persons (other than any foreign affiliate of a taxpayer resident in Canada),
(ii) owned by trustees for the benefit of non-resident persons or their unborn issue, or
(iii) owned by a non-resident-owned investment corporation, all of the issued shares of which and all of the bonds, debentures and other funded indebtedness of which were beneficially owned by non-resident persons or owned by trustees for the benefit of non-resident persons or their unborn issue or by two or more such corporations;
(b) its income for each taxation year ending in the period was derived from
(i) ownership of or trading or dealing in bonds, shares, debentures, mortgages, bills, notes or other similar property or any interest therein,
(ii) lending money with or without security,
(iii) rents, hire of chattels, charterparty fees or remunerations, annuities, royalties, interest or dividends,
(iv) estates or trusts, or
(v) disposition of capital property;
(c) not more than 10% of its gross revenue for each taxation year ending in the period was derived from rents, hire of chattels, charterparty fees or charterparty remunerations;
(d) its principal business in each taxation year ending in the period was not
(i) the making of loans, or
(ii) trading or dealing in bonds, shares, debentures, mortgages, bills, notes or other similar property or any interest therein;
(e) it has, not later than 90 days after the commencement of its first taxation year commencing after 1971 elected in prescribed manner to be taxed under this section; and
(f) it has not, before the end of the last taxation year in the period, revoked in prescribed manner the election so made by it;
except that in no case shall a new corporation (within the meaning assigned by section 87) formed as a result of an amalgamation after June 18, 1971 of two or more predecessor corporations be regarded as a non-resident-owned investment corporation unless each of the predecessor corporations was, immediately before the amalgamation, a non-resident-owned investment corporation;
[18] There is unequivocal evidence that five of the six conditions in the definition of NRO were satisfied in 1996. I will summarize the evidence with respect to those conditions in the same order as they appear in the statute:
(a) All of the Appellant's issued shares were beneficially owned by Banner USA, a non-resident, from incorporation to the end of December 1996.
(b)(iii) All of the Appellant's income for 1996 was derived from interest or dividends.
(c) No part of the Appellant's gross revenue for 1996 was derived from restricted sources.
(d) In dispute!
(e) Exhibits 15 and 16 prove that the Appellant elected to be an NRO on March 22, 1996; and the election was accepted as valid by Revenue Canada. See paragraph 8 above.
(f) There is no evidence that the Appellant ever revoked its election to be an NRO. Mr. Butalia stated that it was not necessary to revoke the election because, in his view, the Appellant was disqualified from being an NRO for 1996 because its principal business in that year was the making of loans - contravening condition (d).
[19] Regulation 500 describes the manner in which a corporation may elect to be an NRO and the manner in which a corporation may revoke a prior election.
500 Any election by a corporation to be taxed under section 133 of the Act shall be made by forwarding by registered mail to the Director-Taxation at the District Office of the Department of National Revenue, Taxation that serves the area in which the head office of the corporation is located the following documents:
(a) a letter stating that the corporation elects to be taxed under the said section 133;
(b) a certified copy of the resolution of the directors of the corporation authorizing the election to be made; and
(c) a certified list showing
(i) the names and addresses of the registered shareholders and the number of shares of each class held by each,
(ii) the names and addresses of the holders of the corporation's bonds, debentures, or other funded indebtedness, if any, and
(iii) the names and addresses of the beneficial owners of shares, bonds, debentures, or other funded indebtedness in cases where the registered shareholders or holders, as the case may be, are not the beneficial owners.
501 Any election to be taxed under section 133 of the Act shall be revoked by a corporation by forwarding by registered mail to the Deputy Minister of National Revenue for Taxation at Ottawa the following documents in duplicate:
(a) a letter stating that the corporation revokes its election; and
(b) a certified copy of the resolution of the directors of the corporation authorizing the election to be revoked.
The requirement to produce a certified copy of the authorizing directors' resolution to elect or to revoke indicates that those decisions are serious matters.
[20] The principal issue in this case may be reduced to the basic question arising from the fourth condition in the definition of an NRO: was the Appellant's principal business in 1996 the making of loans? Counsel for the Appellant argued strongly in the affirmative that the making of loans was the Appellant's principal business in 1996. For the reasons which follow, I do not accept the Appellant's argument. In a nutshell, my conclusions are that (i) the Appellant did not make any loans in 1996; (ii) if the Appellant made one or more loans in 1996, such loans were not made as part of any business; and (iii) the Appellant did not have any business in 1996 and, accordingly, the Appellant could not have had a principal business in 1996. I will explain how I reach these conclusions.
[21] Did the Appellant make any loans in 1996? Appellant's counsel referred to the definition of "loan" in Black's Law Dictionary, sixth edition:
Loan. A lending. Delivery by one party to and receipt by another party of sum of money upon agreement, express or implied, to repay it with or without interest. ... Anything furnished for temporary use to a person at his request, on condition that it shall be returned, or its equivalent in kind, with or without compensation for its use. ...
In Bradley v. The Queen, 96 DTC 2040, I referred to the following definition of "loan" at page 2043:
A "loan" is a contract by which one delivers a sum of money to another and the latter agrees to return at a future time a sum equivalent to that which he borrows.
A "loan" within the law of usury is the delivery of a sum of money to another under a contract to return at some future time an equivalent amount with or without an additional sum agreed upon for its use.
To constitute a "loan", there must be an express or implied agreement whereby one person advances money to another, who agrees to repay it on such terms as to time and rate of interest, or without interest, as parties may agree. Words and Phrases, Permanent Edition, Volume 25A, Page 79.
The above definitions refer to a "delivery" or "advance" of money. The Appellant never had any money in 1996 to deliver or advance. The Appellant received two promissory notes from Banner Canada but those notes were only evidence of Banner Canada's liabilities to the Appellant with respect to a reduction of stated capital ($852,225) not yet distributed to the shareholder, and a dividend ($5,647,775) not yet paid to the shareholder.
[22] Both counsel referred to the decision of the Supreme Court of Canada in T.E. McCool Limited v. M.N.R., 49 DTC 700. In that case, Mr. McCool sold certain assets to his company and, as consideration for the assets, the company assumed Mr. McCool's business liabilities; paid a small amount of cash; issued 600 fully paid shares; and delivered a promissory note for $123,097. One of the issues before the Court was whether the company could deduct interest on the promissory note. The relevant section of the Income War Tax Act stated:
5(1) "Income" as hereinbefore defined shall for the purpose of this Act be subject to the following exemptions and deductions: --
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(b) Such reasonable rate of interest on borrowed capital used in the business to earn the income as the Minister in his discretion may allow ...
All five judges who heard the McCool case agreed that interest on the promissory note was not deductible. Estey J. stated at page 708:
Terms such as "borrowed capital", "borrowed money" in tax legislation have been interpreted to mean capital or money borrowed with a relationship of lender and borrower between the parties. Inland Revenue Commissioners v. Port of London Authority, [1923] A.C. 507; Inland Revenue Commissioners v. Rowntree & Co. Ltd., [1948] 1 All E.R. 482; Dupuis Frères Ltd. v. Minister of Customs and Excise, [1927] Ex. C.R. 207. It is necessary in determining whether that relationship exists to ascertain the true nature and character of the transaction. In this case the promissory note arises out of an exchange in which, as already detailed, the purchase price was paid by assuming outstanding obligations, a small payment of cash, allotment of capital stock and the execution and delivering of this promissory note. Under such circumstances it cannot be held that the relationship of lender and borrower in respect to this note exists between the respondent company and the payee of the note.
Along the same line of thought, Kellock J. stated at page 712:
In the second appeal the company claims that the interest paid on the note given to McCool for the balance of the purchase price of the assets acquired by the company should be allowed as an operating expense on the ground that the note represents borrowed capital used in the business to earn the income within the meaning of section 5(1)(b) of the statute. This claim was disallowed by the Minister and the company's appeal was dismissed by the learned trial judge, on the ground that in order to qualify under the statute the taxpayer would have to be in the position of a borrower and some other person would have to be a lender, while in fact there was no such relationship as between the company and McCool. I agree with the learned trial judge that the company cannot bring itself within the language used in section 5(1)(b). To employ the language of Viscount Finlay in Commissioners of Inland Revenue v. Port of London Authority, [1923] A.C., 507 at 514, in order to enable the statute to apply, "there must be a real loan and a real borrowing". Here there is nothing more than unpaid purchase money secured by a promissory note which, in my opinion, is insufficient. ...
[23] Mr. Reynolds, the Appellant's first witness, stated that Banner Canada delivered promissory notes to the Appellant because it did not have the funds to pay the dividend of $5,647,775 or to distribute the reduction in stated capital of $852,225. After the promissory notes were delivered, there was a real liability owing by Banner Canada to the Appellant. The books and records of both companies recorded that liability. The Appellant's balance sheet (Exhibit 27) erroneously shows Banner Canada's liability as a "loan receivable". There was no "loan receivable". There was a creditor/debtor relationship between the Appellant and Banner Canada but it was not the result of any lending or borrowing. The creditor/debtor relationship was the result of Banner Canada's inability to pay the dividend or distribute the reduction in stated capital.
[24] When a purchaser does not have enough funds to pay the purchase price for certain property but delivers to the vendor a promissory note for all or part of the purchase price, the purchaser has become a debtor of the vendor but the purchaser has not borrowed any money from the vendor; nor has the vendor loaned any money to the purchaser. That is the principle of the McCool case. By parallel reasoning, if a corporation like Banner Canada declares a dividend and does not have enough funds to pay the dividend but delivers to its sole shareholder a promissory note, the corporation has become a debtor of its sole shareholder but the corporation has not borrowed any money from its shareholder; nor has the shareholder loaned any money to the corporation.
[25] A recent decision of the Federal Court of Appeal applies the principle of McCool in circumstances similar to the facts herein. In Parthenon Investments Ltd. v. M.N.R., 97 DTC 5343, the corporate taxpayer declared a dividend payable to its parent corporation; and "paid" the dividend by delivering an interest-bearing promissory note. The corporate taxpayer deducted the interest on the note when computing income but the Minister disallowed the deduction. The corporate taxpayer had to come within the terms of paragraph 20(1)(c) of the Act which permits the deduction of interest owed on "borrowed money". The Federal Court of Appeal cited McCool and held against the corporate taxpayer. MacGuigan J.A. stated at page 5344:
We are all agreed that the learned Tax Court Judge was right in holding that the appellant did not borrow money on which it could deduct interest as required by subpar. 20(1)(c)(i) of the Act. In the words of Locke, J. (sic) in Minister of National Revenue v. T.E. McCool Limited (1949), 49 DTC 700, 712, in interpreting the same provisions, "in order to qualify under the statute the taxpayer would have to be in the position of a borrower and some other person would have to be a lender." More recently, Stone J.A. has made the same point for this Court in The Queen v. MerBan Capital Corporation Limited (1989), 89 DTC 5404, 5413:
What is fatal to the Respondents' case in my view is that paragraph 20(1)(c) requires that for interest to be deductible it must be paid pursuant to money borrowed by the taxpayer and not by someone else. The taxpayer must have created a borrower-lender relationship which gives rise to interest being paid.
[26] The Appellant relies on the 1950 decision of the Tax Appeal Board in Modern Dairies Ltd. v. M.N.R., 50 DTC 442. The corporate taxpayer declared a dividend and Mr. S. (one of its shareholders) was thereby entitled to receive $60,935. When the dividend was declared, Mr. S. and the corporation agreed that he would loan $60,000 to the corporation with interest at 4½% per annum. The corporation deducted in 1947 the interest which it paid to Mr. S. with respect to the $60,000 loan. In my view, Modern Dairies is distinguished by the contemporaneous agreement to lend almost the whole amount of the dividend back to the corporation at a rate of 4½% per annum. The chairman of the Tax Appeal Board referred to the then recent decision of the Supreme Court in McCool but he allowed the appeal and did not follow McCool. If the decision in Modern Dairies is not distinguished by the contemporaneous loan agreement, I question whether it is good law having regard to McCool and Parthenon.
[27] The Appellant also relies on the 1951 decision of the Tax Appeal Board in Boyles Bros. Drilling Company Ltd. v. M.N.R., 51 DTC 70. After declaring a dividend, the corporate taxpayer wrote to each shareholder asking if the shareholder would lend his proportionate share of the dividend to the corporation for five years with interest at 5% per annum. The corporation deducted the various amounts of interest but the Minister disallowed the deductions. In its decision, the Board referred to McCool but followed Modern Dairies and allowed the appeal. Again, I view the positive loan agreements between the corporation and its shareholders as distinguishing Boyles Bros. from the Appellant's circumstances but, even if I should be wrong, I question whether Boyles Bros. is good law. McCool and Parthenon are strong authorities against the Appellant on this primary issue.
[28] Having regard to all of the documentary exhibits, there is no objective evidence of any intention on the part of the Appellant or Banner Canada to regard either the $852,225 or the $5,647,775 as loans. The closing agenda (Exhibit 19) does not refer to any loan transaction. The resolution of Banner Canada directors (Exhibit 10) does not refer to borrowing or lending. And the internal accounting records of the Appellant and Banner Canada (Exhibits 28, 29 and 30) do not refer to loans. Those accounting records do, however, refer to "note".
[29] Relying on what I perceive to be the principle of law established in McCool and Parthenon, I conclude that the Appellant did not make any loans to any person in 1996. If I should be wrong, and if it could be held in law that the Appellant did lend money to Banner Canada in 1996, was the Appellant in the business of making loans in 1996? When considering this question, it may be helpful to review the decision of the Supreme Court of Canada in Canadian Marconi Company v. The Queen, 86 DTC 6526. When distinguishing between income from business and income from property, Wilson J. stated at pages 6529-6530:
... It is trite law that the characterization of income as income from a business or income from property must be made from an examination of the taxpayer's whole course of conduct viewed in the light of surrounding circumstances: see Cragg v. Minister of National Revenue, [1952] Ex. C.R. 40, [52 DTC 1004], per Thorson P. at p. 46. In following this method courts have examined the number of transactions, their volume, their frequency, the turnover of the investments and the nature of the investments themselves. ...
[30] When trying to decide if the Appellant was in any business in 1996, I would observe that the Appellant did not initiate any transactions on its own. The Appellant was the passive recipient of two promissory notes which resulted from two transactions of Banner Canada. It is difficult to examine the number, volume or frequency of transactions when there are none at all to examine. Apart from acquiring all of the issued shares of Banner Canada which was the sole reason for its incorporation, the Appellant was totally passive in 1996. I have no hesitation in concluding that the Appellant did not engage in any business in 1996. Therefore, it could not have as its principal business "the making of loans" when it did not have any business at all. I reach this conclusion fully cognizant of the broad meaning given to the word "business" in section 248 of the Act.
[31] The Appellant cannot succeed on the principal issue. It was an NRO at all relevant times in 1996. It elected to be an NRO. It did not revoke its election. And it did not engage in any transaction or transactions which would have disqualified it from remaining an NRO throughout 1996.
Did the Appellant receive in 1996 a dividend of $5,647,775?
[32] On the second issue, the Appellant argues that, if it was an NRO in 1996, then the dividend of $5,647,775 was not received and, therefore, no part of the dividend should be included in the Appellant's income for 1996. I find no merit in this argument.
[33] Considering the content of the Appellant's T2 corporate income tax return for 1996 (see Exhibit 22), the Appellant certainly regarded itself as having received a dividend in the amount of $5,647,775. On the list of Information Schedules, the Appellant answered "Yes" to item no. 57: "Has the corporation received any dividends or paid any taxable dividends for purposes of the dividend refund?" And in the box segregated for "Taxable income and base amount of Part I Tax", the Appellant showed $5,647,775 as "Taxable dividends deductible under section 112 or 113, or both (item 57)".
[34] Although neither counsel argued the contrast between the "cash method" and "accrued method" of accounting, and there was no expert evidence on generally accepted accounting principles ("GAAP"), it seems to me that the Appellant cannot succeed on the second issue unless it claims that it is entitled to adopt the cash method of accounting. After declaring the dividend, Banner Canada did not pay the dividend by cheque, money order or other means of transferring cash. Quite the contrary. The resolution declaring the dividend (Exhibit 10) provides " ... such dividend ... to be payable by the Corporation by the issuance of a demand promissory note ... ". A promissory note is, of course, not payment but only a promise to pay and, therefore, evidence of a debt or obligation.
[35] Notwithstanding the absence of any payment, the Appellant recorded the dividend in its books of account as if the dividend had been paid. In its 1996 financial statements (Exhibit 27), the Appellant shows revenue ("Dividends") of $5,647,775 (the precise amount of the dividend from Banner Canada) and retained earnings of the same amount described as "Net income for the year, representing retained earnings, end of year". The balance sheet shows a receivable of $6,500,000 which is the aggregate of the two promissory notes representing the dividend ($5,647,775) plus the reduction in stated capital ($852,225). The receivable of $6,500,000 is an important component of the Appellant's balance sheet at December 31, 1996 permitting its assets to be in balance with its liabilities and shareholder equity.
[36] The financial statements (Exhibit 27) are a clear indication that the Appellant in fact adopted the accrual method of accounting and not the cash method. The Appellant may not have had any choice. I question whether any corporation is permitted to adopt the cash method of accounting if it is part of a corporate group having transactions with one or more other corporations in the group which carry on an active business. The circumstances in this appeal are on point. Banner Canada carries on an active business. The Appellant, its parent company, carries on no business. Exhibits 28, 29 and 30 are accounting records of the Appellant and Banner Canada recording the payment of the dividend, the reduction in Banner Canada's stated capital, the issuance of the promissory notes, and the accrual (and later reversal) of interest on the notes. Having regard to these intercorporate transactions, in order to be consistent, the books and records of the Appellant would have to be a mirror image of the books and records of Banner Canada.
[37] In an old case, Ken Steeves Sales Ltd v. M.N.R., 55 DTC 1044, the Exchequer Court held that, when determining the profit or loss of a business, the cash method of accounting is not permissible under the Act. Cameron J. stated at page 1050:
For these reasons I must reach the conclusion that the "Cash Receipts and Expenditure" method purported to have been used by the appellant in this case is a method which is not permissible under the Act. I say that because of the fact that it excludes as an item of income all receivables, which in my opinion form a necessary part of any trader's profit and loss statement. Such a method is incomplete and misleading and one which fails entirely to show the true state of a taxpayer's position or to reflect his true profit or loss. ...
I am not aware of any subsequent case which has diminished the effect of Ken Steeves Sales.
[38] There is an underlying assumption in the Income Tax Act that income from business or property will be determined by the accrual method of accounting. Many examples support that underlying assumption. When computing income:
- paragraph 12(1)(b) requires receivables to be included;
- paragraph 18(1)(a) permits the deduction of expenses incurred; and
- paragraph 20(1)(l) permits the deduction of a reserve for doubtful debts.
In section 28, there is explicit permission to use the "cash method" to compute income from farming and fishing. Without such explicit permission, it appears to me that farmers and fishermen would be required to use the accrual method of accounting.
[39] In my opinion, the Appellant has no choice. It must adopt the accrual method of accounting. It cannot adopt the cash method. It must include in its income for 1996 the amount of the dividend represented by the promissory note for $5,647,775. The appeal is dismissed, with costs.
Signed at Ottawa, Canada, this 26th day of February, 2003.
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"M.A. Mogan" |
J.T.C.C.
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CITATION: |
2003TCC82 |
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COURT FILE NO.: |
2001-199(IT)G |
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STYLE OF CAUSE: |
Banner Pharmacaps NRO Ltd. and Her Majesty the Queen |
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PLACE OF HEARING: |
Calgary, Alberta |
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DATE OF HEARING: |
April 11, 2002 |
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REASONS FOR JUDGMENT BY: |
The Honourable Judge M.A. Mogan |
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DATE OF JUDGMENT: |
February 26, 2003 |
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APPEARANCES: |
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Counsel for the Appellant: |
Michel Bourque & Curtis Stewart |
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Counsel for the Respondent: |
Julia S. Parker |
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COUNSEL OF RECORD: |
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For the Appellant: |
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Name: |
Michel Bourque |
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Firm: |
Bennett Jones |
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For the Respondent: |
Morris Rosenberg Deputy Attorney General of Canada Ottawa, Canada |