Riviera Hotel Co. Ltd. v. MNR, 72 DTC 6142, [1972] CTC 157 (FCTD)

Cattanach, J:—This is an appeal from a decision of the Tax Appeal Board dated December 10, 1970, reported [1970] Tax ABC 1303, whereby the assessment of the appellant by the Minister with respect to its 1966 taxation year was confirmed.

The facts are not in dispute and the issue is succinctly set out in paragraph 21 of an agreed statement of facts which reads as follows:

The parties hereto by their respective solicitors, hereby admit the facts and documents hereinafter set forth provided that:

(a) such admissions are made for the purposes of this appeal only and may not be used against either party by any other person or on any other occasion;

(b) the parties hereto reserve their right to object to the relevancy of any of the said facts and documents; and

(c) either party may adduce further and other evidence relevant to this appeal and not inconsistent with this agreement.

1. The Appellant has, at all times relevant to the appeal herein, carried on business in the City of Edmonton, in the Province of Alberta as the owner and operator of a hotel.

2. On or about August 5, 1960, the Appellant borrowed from Credit Foncier Franco-Canadien (herein referred to as Credit Foncier) the sum of $375,000, the said sum to be used for the purpose of earning income from the Appellant’s business.

3. The repayment of the said loan was secured by a mortgage, a copy of which is annexed hereto as Exhibit 1, upon lands and premises owned by the Appellant and described as:

Parcel “A” — Lot Two (2), containing 2.42 acres, more or less, in Block Eighty-eight (88), in the City of Edmonton, as shown on Subdivision Plan 6018 KS

(Allendale NE 17-52-24-W 4)

Reserving thereout all mines and minerals

Parcel “B” — Lot Two A (2A), containing 0.84 of an acre, more or less, in Block Eighty-eight (88), in the City of Edmonton, as shown on Subdivision Plan 6018 KS

(Allendale NE 17-52-24-W 4)

Reserving thereout all mines and minerals

21. The question for the opinion of the Court is whether the amount of $13,108.27 paid by the Appellant as herein described was an expense incurred in the course of borrowing money within the meaning of section 11 (1 )(cb)(ii) of the Income Tax Act, the deduction of which is not precluded by sections 11 (1 )(cb)(iii) and 11 (1 )(cb)(iv) of the Income Tax Act, so as to be deductible in computing the Appellant’s loss from its business for the 1964 taxation year.

22. If the Court shall be of the opinion that the said amount is not deductible in computing the Appellant’s income then Judgment shall be entered for the Respondent dismissing the appeal with costs. If the Court shall be of the opinion that the said amount is deductible in computing the Appellant’s income then Judgment shall be entered for the Appellant allowing the appeal with costs and referring the assessment back to the Respondent for the purpose of re-assessing in accordance with the opinion of this Court.

There are five exhibits to the agreed statement of facts:

Exhibit 1 is a copy of the mortgage.

Exhibit 2 is proposal for prepayment by the appellant as mortgagor to the mortgagee.

Exhibit 3 is the acceptance of that proposal by the mortgagee.

Exhibit 4 is an agreement between the appellant and the Provincial Treasurer of Alberta.

Exhibit 5 is a debenture of the appellant in favour of the Provincial Treasurer.

For the purposes of these reasons I do not consider it necessary to reproduce the exhibits in detail. Their material effects are reflected in the agreed statement of facts.

However it is advantageous to summarize the facts giving rise to this appeal.

The appellant had borrowed the sum of $375,000 to construct a hotel, with interest at 734% secured by a first mortgage on the premises. The mortgage did not provide for the prepayment of the moneys owing thereunder. The appellant’s potential favourable business opportunities dictated the expansion of its hotel accommodation. To do so required the borrowing of further funds. The first lender refused to advance the further funds. The appellant arranged to borrow the further funds required by it from another lender at 6% but this lender required that the funds to be advanced by it must be secured by a first charge on the appellant’s premises. To satisfy this condition the appellant had to discharge the existing first mortgage which did not contain a provision for prepayment. The first lender agreed to permit the appellant to prepay the entire principal balance owing under the mortgage with interest to the date of repayment plus a bonus equivalent to six months’ interest which amounted to $13,108.27. This the appellant did and borrowed money from the second lender.

The issue is whether the amount of $13,108.27 so paid by the appellant to the first lender as a bonus to enable the appellant to discharge the mortgage held by the first lender in order that the appellant might borrow further funds from the second lender was an expense of borrowing money within the meaning of subparagraph 11 (1 )(cb)(ii) of the Income Tax Act, the deduction of which is not precluded by subparagraphs 11 (1 )(cb)(iii) and 11 (1 )(cb)(iv) so as to be deductible in computing the appellant’s income.

Subparagraphs 11 (1 )(cb)(ii), (iii) and (iv) read as follows:

11. (1) Notwithstanding paragraphs (a), (b) and (h) of subsection (1) of section 12, the following amounts may be deducted in computing the income of a taxpayer for a taxation year:

(cb) an expense incurred in the year,

(ii) in the course of borrowing money used by the taxpayer for the purpose of earning income from a business or property (other than money used by the taxpayer for the purpose of acquiring property the income from which would be exempt),

but not including any amount in respect of

(iii) a commission or bonus paid or payable to a person to whom the shares were issued or sold or from whom the money was borrowed, or for or on account of services rendered by a person as a salesman, agent or dealer in securities in the course of issuing or selling the shares or borrowing the money, or

(iv) an amount paid or payable as or on account of the principal amount of the indebtedness incurred in the course of borrowing the money, or as or on account of interest;

In British Columbia Electric Railway Co, Ltd v MNR, [1958] SCR 133; [1958] CTC 21, Mr Justice Abbott said at page 137 [31]:

Since the main purpose of every business undertaking is presumably to make a profit, any expenditure made “for the purpose of gaining or producing income” comes within the terms of Section 12(1)(a) whether it be classified as an income expense or as a Capital outlay.

Once it is determined that a particular expenditure is one made for the purpose of gaining or producing income, in order to compute income tax liability it must next be ascertained whether such disbursement is an income expense or a Capital outlay.

The leading authority for the proposition that the cost of financing a business is a capital expense is in Montreal Coke and Manufacturing Co v MNR, [1944] AC 126; [1944] CTC 94. In that case interest bearing bonds were converted into other securities carrying lower rates of interest. It was claimed that the expenses of conversion were incurred “for the purpose of earning income”. The Supreme Court of Canada held ([1942] CTC 1) that the payments on that account were not for that purpose and that, in any event, the expenses were outgoings of capital and accordingly were not deductible. This decision was upheld by the Privy Council on the first ground.

This decision was followed by the Supreme Court of Canada in Bennet & White Construction Co Ltd v MNR, [1949] SCR 287; [1949] CTC 1, where it was held that commission payments were not allowable as deductible expenses since they were incurred in connection with the financing of the business and were not related to the income earning process.

Paragraph 11 (1)(cb) was added to the Income Tax Act by subsection 1(1), Statutes of Canada, 1955, chapter 54 applicable to the 1955 and subsequent taxation years. The obvious purpose of this section is to permit the deduction of certain expenses incurred in raising funds by borrowing or by the issue of capital stock which were previously not deductible, as indicated in the two decisions referred to immediately above, because those expenses were not directly related to the earning of income or were outlays or payments on account of capital or replacement of capital within the meaning of paragraphs 12(1)(a) and (b).

In paragraphs 2, 5 and 10 of the agreed statement of facts it is agreed between the parties that the money originally borrowed by the appellant from the first lender, the additional money sought to be borrowed by the appellant from the first lender which was refused and the money subsequently borrowed by the appellant from the second lender was for use by the appellant “for the purpose of earning income from” its business.

In view of the statement of Mr Justice Abbott in British Columbia Electric Railway Co, Ltd case (supra) quoted above to the effect that since the purpose of any business is to make a profit, it follows most expenditures are made for the purpose of gaining or producing income from the business and deductibility thereof for income tax purposes is dependent upon the outlay or expense being an income expense or a capital outlay. I agree that moneys which were borrowed by the appel- lant from both the first lender and the second lender was “money used by the taxpayer for the purpose of earning income from a business” within the meaning of those words as they appear in subparagraph 11 (1)(cb)(ii).

Accordingly it follows that whether the sum of $13,108.27 paid out by the appellant in the circumstances above described is “an expense incurred in the year in the course of borrowing money” falls to be determined on the interpretation of paragraph 11 (1)(cb) without reference to section 12. The words of subsection 11(1) are, “Notwithstanding paragraphs (a), (b) and (h) of subsection (1) of section 12, the following amounts may be deducted in computing the income of a taxpayer for a taxation year” and paragraph (cb) is included.

In commenting on paragraph 11(1)(cb) my brother Heald said in Canada Permanent Mortgage Corporation v MNR, [1971] CTC 694 at 699; [1971] DTC 5409 at 5412:

This subsection operates to permit a taxpayer to deduct expenses incurred in the course of borrowing money used by the taxpayer to earn income from his business whether or not it is prohibited by section 12(1)(a), (b) and (h). . . .

Reverting to the facts in this appeal it is significant to recall that there were two different and distinct borrowings. The appellant sought to obtain further funds from the first lender. Under the mortgage held by the first lender principal and interest remained unpaid and the mortgage contained no provision for prepayment to the first lender. The appellant, having made the commercial decision to expand its hotel facilities by which it expected to earn still further money from its business, was compelled to seek the further necessary funds from another source. This the appellant succeeded in doing but subject to the second lender having a first charge on the appellant’s premises. To meet this condition required by the second lender the appellant was compelled to pay all arrears of principal and interest and in addition was obliged to pay to the first lender the sum of $13,108.27 as a bonus, computed by the yardstick of the equivalent of interest for six months, for the privilege of discharging the mortgage before maturity.

Basically the position taken by counsel for the appellant was that the payment of $13,108.27 to the first lender was an expense in the course of borrowing from the second lender.

I do not accept that proposition. The payment of $13,108.27 by the appellant was not a payment of interest nor a payment in lieu of interest to the first lender and it most certainly was not a payment on account of principal. It was a bonus.

In Puder v MNR, [1963] CTC 445, Mr Justice Thurlow pointed out that a mortgagee has other rights besides the payment of principal and interest. One of those rights would be to hold the mortgage until its maturity. The first lender, in the facts of the present appeal, undoubtedly wished to avail itself of that right because it did not include a provision in the mortgage permitting of prepayment by the mortgagor.

Despite the pronounced trend in modern advertising by money lenders to emphasize the ease of obtaining money on loans and omitting a reference to or placing minimal emphasis on the fact that the lender expects to be repaid, nevertheless, as was said by Buckley, J in In re Southern Rio Grande Do Sol Railway Company Limited, [1905] 2 Ch 78 at 83, “borrowing necessarily implies repayment at some time and under some circumstances”.

The payment of $13,108.27 by the appellant to the first lender was not a payment for the use of the money obtained from the first lender. This payment was made to the first lender as an inducement or bonus for the first lender to forego its right to hold its first mortgage to maturity and to accord to the appellant the privilege of paying the balance of principal and interest under the mortgage, which it was the appellant’s obligation to do ultimately, prior to the due dates. The payment of the sum of $13,108.27 was an expense incurred for this purpose.

The payment was not made in the course of borrowing money from the first lender but it was made in the course of repaying that money. This being so it follows that the payment to the first lender cannot be construed as an expense incurred by the appellant in the course of borrowing money from the second lender.

I would add that the foregoing reasoning is substantially the same as that adopted by the Chairman of the Tax Appeal Board in Dominion Electrohome Industries, Ltd v MNR, 29 Tax ABC 159; 62 DTC 256.

in that case the appellant arranged a $1,000,000 debenture issue to provide further working capital. It was a condition that to arrange this subsequent debenture issue a prior $250,000 debenture issue had to be discharged. In order to retire the first debenture issue the appellant was obliged to pay a premium of $6,117. The appellant sought to deduct this premium as an expense incurred in the course of borrowing money used for the purpose of earning income from the appellant’s business within the meaning of paragraph 11(1)(cb). The Minister disallowed the deduction so claimed.

On appeal to the Tax Appeal Board, the Chairman held that the premium of $6,117 paid by the appellant was not deductible and dismissed the appeal. He said at pages 168-9 [261-2]:

There is no doubt that the payment of $6,117 was made with a view to increasing, eventually, the appellant’s income. However, in order to benefit by the provisions of paragraphs (c) or (cb) of section 11(1) — which deal specifically with payments made in connection with borrowing money for use in a taxpayer’s business — a taxpayer must show that the amount was paid either as interest on borrowed money used for the purpose of earning income from its business or that it was an expense incurred in the year in the course of borrowing money used for the purpose of earning income from its business. Clearly the payment of $6,117 was not made for the use of money borrowed under the first debenture issue, and it was not an expense arising in the course of borrowing money for which the debentures were issued. Instead this payment was made because the appellant wished to repay and did repay the balance outstanding on the first debenture issue. No provision is made in the Income Tax Act for the deduction of interest or bonus paid in the course of repaying borrowed capital.

The reasoning adopted by the Chairman commends itself to me as being irreproachable and it coincides with the reasoning I have adopted in the present appeal.

In view of the conclusion I have reached, which is that the expense incurred by the appellant herein was not an expense incurred in the course of borrowing money from the second lender but was an expense incurred in the course of repaying the money borrowed from the first lender and accordingly the expense does not fall within subparagraph 11 (1 )(cb)(ii), it is not necessary for me to consider whether the deduction is precluded by subparagraphs 11 (1 )(cb)(iii) and (iv).

The appeal is dismissed with costs.