Tuesday, 14 May 2013

Interest Deduction Denied: Swirsky

In Swirsky (2013 TCC 73) the TCC concluded that interest paid on a loan incurred for the purpose of a share purchase was not deductible under subparagraph 20(1)(c)(i). The decision touches upon the issue of whether the gross expected dividend return on shares places a limit on the deductibility of interest expense related to their purchase.

Mr. Swirsky, the taxpayer, held shares in Torgan Construction Limited, a corporation actively engaged in real estate development. The taxpayer incorporated Torgan in 1974 and his wife became an equal shareholder a few years after their marriage. The 1989 decline in the real estate market created the very real possibility of bankruptcy to the taxpayer. Just before the market peaked, the taxpayer and Mr. Cohen embarked on an ambitious development and each provided joint and several personal guarantees to a bank. The project was cancelled and when the taxpayer learned from Mr. Cohen that he was creditor proof, he had reasonable concerns that the bank would seek to collect the entire loan amount under his personal guarantee. The taxpayer sought to place the Torgan shares out of the lender’s reach by selling them to his wife and by using the sale proceeds to pay down shareholder loans that he owed to Torgan.

Torgan had not made a practice of paying dividends and instead paid bonuses and extended significant shareholder loans to the taxpayer to achieve the deductibility of amounts paid out of its income. Arguably on the facts a preference existed, because Mr. Swirsky knew that he was potentially facing bankruptcy, his wife believed that bankruptcy was imminent, and the transaction was entered into to preserve family income, but the court concluded that the transaction was an effective creditor-proofing measure.

In Shell ([1999] 3 SCR 622) the SCC concluded that four requirements support an interest deduction under paragraph 20(1)(c): (1) the amount must be paid in the year or be payable in respect of the year of deduction; (2) the amount must be paid pursuant to a legal obligation to pay interest on borrowed money; (3) the borrowed money must be used for the purpose of earning non-exempt income from a business or property; and (4) the amount must be reasonable in light of the first three requirements. 

The TCC in Swirsky focused on the third requirement: whether the borrowed money was used for the purposes of earning non-exempt income. Based on Ludco, although personal intention is not determinative, the TCC in Swirsky said that clearly the wife  purchased the shares without any understanding of their potential for income. And there was little objective history of the payment of dividends on those shares before their transfer to the wife. Interestingly, dividends were paid on the shares after their transfer. The TCC largely ignored the post-transfer conduct, but pointed out that the first dividend paid was a non-taxable capital dividend, and the first taxable income after the shares’ transfer occurred in 2003, over seven years after the transfer’s final stage. (The accountants advised to transfer the shares in three tranches in order to match the shareholder loans outstanding.) According to the TCC, Ludco required that there must be a reasonable expectation of income at the time that the investment was made.

On the facts presented, there is a strong implication that the wife agreed to purchase the shares in order to facilitate a creditor-proofing transaction, independent of any desire to earn income. The TCC also concluded that the spouses agreed between themselves that the wife would not be responsible for the loan costs. The court concluded that thus it was more likely than not that the wife was not concerned with the shares’ income-earning potential at the time of their purchase.

The TCC appears to be correct in concluding that based on a lack of dividend history, a reasonable buyer could not anticipate income, and thus the wife had no reasonable expectation of earning income from the shares acquired with the loan. The wife’s lack of understanding of the economic consequences augments the conclusion that there was no reasonable expectation of earning income from the shares. Arguably a history of dividend payments prior to the transfer might have resulted in a different conclusion because it would justify an objectively supported and reasonable belief that the shares would earn income. However, the focus on dividend payments as the predominant source of income from shares may seem too narrow in the context or a personally held corporation, because many taxpayers earn different types of income from a corporation, such as salary, bonuses, loans, and dividends. Salary and bonuses are generally used to entice employees to reach their top performance.

In our view the TCC in Swirsky was correct to focus on dividends. The CBCA provides two economic rights that must be allotted to classes of shares: the right to receive any dividend declared by the corporation and to receive the remaining property of the corporation on dissolution. Other rights, such as a conversion right or a right of redemption, attach to the share, not the shareholder (Bowater Canada Ltd v RL Crain Inc (1987), 62 O.R. (2d) 752, 46 D.L.R. (4th) 161, 26 O.A.C. 348, 39 BLR 34). Thus while most other forms of compensation, such as salary and bonuses, are tied to acts done on the corporation’s behalf, dividends are the product of two factors. First, the directors must decide to declare a dividend, further to their obligation to manage the business and affairs of the corporation. Second, the shareholder must own a share that has the right to participate in the dividend declared. If both elements are present, the principle of equality demands that the share receive the dividend (McClurg, [1990] 3 SCR 1020) and no further acts by the shareholder on the corporation’s behalf are required to justify the payment of the dividend (Neuman, [1998] 1 SCR 770).

Sunita Doobay
TaxChambers, Toronto

Darcy L. MacPherson
Faculty of Law, University of Manitoba

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