Ludco Enterprises Ltd. v. Canada
T-742-93
Lutfy J.
9/12/97
37 pp.
Appeals by way of trial de novo from Tax Court decision confirming reassessments disallowing deductibility of interest costs-Between 1977 and 1979, plaintiffs borrowed $6.5 million and invested $7.5 million to acquire shares of offshore (Panamanian) investment companies (Justinian Corp. S.A and Augustus Corp. S.A) in business of investing in Canadian and United States dollar denominated fixed income securities-Plaintiffs incurred interest costs of $6 million and earned dividends of $0.6 million-Plaintiffs sought to deduct interest costs against other reported income for taxation years 1981 through 1985 on basis: (1) dividends income from business or property within meaning of Income Tax Act, s. 20(1)(c)(i), where test income, not profit or net income; (2) even if test profit, plaintiffs had reasonable expectation in 1977 that (i) dividends would eventually exceed interest expense, or (ii) dividends together with gains on disposition would result in profit which was in fact realized-Defendant arguing real purpose of plaintiffs' investments with borrowed funds to allow Justinian's earnings to accrue and, upon eventual disposition of shares, taxation of profits would be limited to capital gains treatment-Borrowed funds not used for purpose of earning income from business or property and plaintiffs never had reasonable expectation of profit from dividend payments-In response to defendant's argument investments made solely to realize capital gains, plaintiffs argue, in alternative, transactions adventure in nature of trade and interest expenses would be deductible as having been incurred on loans used to generate business income-Appeals dismissed-Principal objectives of Justinian tax deferral and savings to be achieved principally by reinvestment of earnings and redemption of shares upon disposition-Justinian would be incorporated in Panama and managed outside Canada and United States so income and profits would not be taxed therein-Directors would be principally non-residents-When Foreign Accrued Property Income (FAPI) tax rules took effect in 1976, measures taken (holdings of each investor in Justinian limited to less than 10% of shares) to circumvent impact of FAPI-Other principal objective to minimize taxes on disposition of shares by Justinian shareholders: proceeds of dispositions of shares by Canadian shareholders, whether by sale or redemption, would give rise to taxation as capital gains-As to dividend policy of Justinian, as stated in Explanatory Memorandum, intended to and, from 1978, did declare annual dividend of US$1 for each year of its existence-Testimony establishing plaintiffs would not have invested in Justinian with borrowed funds if had known interests costs not deductible from income-Not answer for plaintiff Ludmer to dismiss fixed-dividend policy as verbiage-Case resulting largely from information in Explanatory Memorandum summarizing essential features developed in planning documents-During 1978 through 1985, plaintiffs' interest costs greater than income received from Justinian in each year-No evidence original intention of Ludmer to hold on to shares through and even beyond 1985-Evidence concerning plaintiffs' expectations of dividend yields even more speculative and less relevant with plaintiff Ludco Enterprises prepared to make fully leveraged investment of $1.4 million in December 1980, when interest rates double those of 1977-Justinian's principal objectives of tax deferral and tax savings to be achieved principally through reinvestment of major portion of savings and redemption of shares upon disposition, not through dividend payments-On evidence, plaintiffs did not expect dividends to cover interest expense-In fact, dividend yield decreased continually-Plaintiffs had no expectation of profit, in sense never expected dividends would exceed interest expense-Profits in investment would be realized upon disposition-As noted in Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32, interest on borrowings used for non-income earning purposes, such as . . . making of capital gains . . . not deductible-Purpose herein to defer taxes through accumulation of earnings and to have profits subject to capital gains treatment on disposition of shares-Earning of dividend income not real purpose of use of borrowed funds-Finally, in applying for shares, plaintiffs represented that acquisitions for purpose of investment; plaintiffs not carrying on business engaged in adventure or concern in nature of trade with investments-Income Tax Act, S.C. 1970-71-72, c. 63, s. 20(1)(c)(i).