Mark Resources Inc. v. The Queen, 93 DTC 1004, [1993] 2 CTC 2259 (TCC)

Bowman, T.C.C.J.:—The appellant appeals from assessments for its 1985 and 1986 taxation years. At issue is the deductibility under paragraph 20(1)(c) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") of $193,684 and $898,241 in interest that it paid on moneys borrowed from the Royal Bank of Canada. Specifically the case has to do with the deductibility of interest on money borrowed as an integral part of a carefully planned and meticulously executed arrangement which had as its economic object the utilization in Canada of losses sustained by a United States subsidiary by their absorption in the profits earned in Canada by the Canadian parent.

The facts are substantially not disputed. The appellant is a successor through two amalgamations in 1988 and 1989 to Precision Drilling Ltd. ("PDL"). PDL was an Alberta corporation that carried on a contract drilling and an oil and gas exploration and production business. In 1985 and 1986 its business was extremely successful and it reported taxable income of $7.2 million and $6.6 million respectively upon which it paid taxes totalling about $5 million.

In 1979 it incorporated a wholly owned subsidiary, Precision Drilling Inc. (“PDI”), under the laws of Colorado to carry on a resource related business in the United States of America. That business did not succeed and by April 30, 1984 it had accumulated business losses of U.S. $707,350. These losses were about to expire in 1985 and 1986 under the loss carry-forward rules of the U.S. Internal Revenue Code. In October of 1984 PDL decided to liquidate its subsidiary by selling or writing down its assets and thereafter PDI ceased to carry on an active business. Although it still had a few oil and gas properties their value was relatively insubstantial. PDI had at this point become essentially a shell whose only real value lay in its accumulated losses, provided that they could be utilized in some manner. To find a way of doing that PDL approached its auditors, Price Waterhouse, who devised a plan that was implemented to the letter, as follows:

On February 22, 1985 PDL borrowed U.S. $7,815,468.11 from the Royal Bank of Canada. The amount of the loan was calculated precisely to permit the borrowed funds to be used to generate enough income in PDI to absorb the losses that were about to expire. The term of the loan was 67 days, i.e. from February 22,1985 to April 30, 1985, the fiscal year end of both PDL and PDI. The interest rate, the London Interbank offering rate (LIBOR) plus one-half a percent, was 95/3 per cent per annum. PDL paid the borrowed funds into PDI’s account and the receipt was recorded as a capital contribution. On the same day the moneys were used by PDI to purchase a term deposit of the Royal Bank. The term deposit was lodged with the London, U.K., branch of the Royal Bank as security for the loan to PDL. The interest paid on the Royal Bank term deposit was 8.75 per cent per annum. Its term, like that of the borrowing, was 67 days and it matured on April 30, 1985 to coincide with the fiscal year end of PDI in order to ensure that the interest on it would be earned in 1985 and be absorbed by PDl’s loss incurred in 1980.

On the same day PDI gave to the Royal Bank of Canada a guarantee of the obligation of PDL in the amount of $7,815,468.11 plus interest at 9 /a per cent per annum.

On April 30, 1985 PDI paid a dividend of CDN $173,982 (U.S. $127,273.73) to PDL which amount represented the interest earned by PDI on the Royal Bank term deposit for the period from February 22 to April 30, 1985. The amount was received by PDL, less 10 per cent United States withholding tax, and recorded as a dividend in the records of PDL. In its taxation year ending April 30, 1985 PDL paid the U.S. dollar equivalent of CDN $193,684 in interest to the Royal Bank in respect of the loan and it deducted it in computing its income.

On April 30, 1985 PDL and the Royal Bank extended the loan with the Royal Bank at LIBOR plus 0.875 per cent. On the same day PDI renewed its term deposit with the Royal Bank at an interest rate of 9.125 per cent per annum maturing on February 11, 1986. The only witness called for the appellant, Mr. R. Winkelaar, was unable to state what the precise rate of interest on the renewed loan from the Royal Bank was as the appellant was unable to obtain the London Interbank offering rate on April 30, 1985. It was however agreed that the rate paid on the loan was higher than the rate paid on the term deposit. A new demand promissory note was given to the bank by PDL but no new loan agreement was executed. PDI’s guarantee of PDL's indebtedness to the Royal Bank remained in place and it deposited the new term deposit with the bank as security for the obligations of itself and PDL.

On February 11,1986, PDI paid a dividend of $794,603 (U.S. $568,548) to PDL, less 10 per cent U.S. withholding tax. This was the amount of interest earned by PDI from the Royal Bank term deposit for the period from April 30, 1985 to February 11, 1986. On the same day PDI cashed in the term deposit and loaned the money to PDL who paid off the Royal Bank.

The loan from the bank, the issuance of the term deposit and its deposit with the bank as security were all done through the London branch of the Royal Bank. No money was ever transferred to Canada or the United States or used in the operations of PDI or PDL, except for the dividends that PDI paid to PDL.

Pursuant to a plan of complete liquidation and dissolution dated April 30, 1986 PDI was liquidated and dissolved. Articles of dissolution were filed with the Department of State of Colorado on May 5, 1986.

In filing its return of income for 1986 under the Income Tax Act PDL deducted in computing its income $898,241, the Canadian dollar equivalent of the interest paid to the bank in U.S. dollars in respect of the loan.

Also, it included in income the gross amount of the dividends received from PDI in 1985 and 1986, $173,982 and $794,603, and then deducted those amounts in computing its taxable income pursuant to section 113 of the Income Tax Act. It did so on the basis, as stated in an attachment to its 1985 return that:

The dividends received are deductible under section 113 of the Income Tax Act as PDI has no exempt or taxable surplus in its fiscal year ended April 30, 1985.

The same reasoning was presumably applied to the dividend received in 1986. I need not examine the accuracy of this somewhat cryptic encapsulation of the complex foreign accrual property income rules. The passive income was earned by a U.S. corporation that was a controlled foreign affiliate of PDL and offset for U.S. tax purposes by prior years’ losses incurred by PDI in carrying on an active business in the United States. It was common ground between the parties that the amount of the dividends received from PDI was deductible in computing PDL's taxable income. Such dividends are not "exempt income" as defined in section 248 of the Act. They are to be included in income under paragraph 12(1)(k) and section 90 and may be deducted in computing taxable income under section 113.

One additional result of the implementation of the plan should be noted. The contribution of capital had the effect of increasing the adjusted cost base of the shares under paragraph 53(1)(c) of the Income Tax Act. That adjusted cost base would have been reduced by the payment of the dividends. Each of these actions — the contribution of capital and the payment of dividends — was an integral part of the scheme and has a specific consequence under the Income Tax Act. Had the scheme not been implemented at all the capital loss reported on the liquidation of PDI would presumably have been different. As a result of the implementation of the plan, one of the integral parts of which was the payment of dividends by the subsidiary, the adjusted cost base of the shares was reduced so that the reported capital loss in 1986 on the liquidation of PDI was $195,315. In addition a foreign exchange loss on capital account of $117,963 was sustained on the repayment of the Royal Bank U.S. dollar loan. Counsel for the appellant asked that, if I held that the interest paid to the Royal Bank was not deductible, I should at least direct that the capital loss of $195,315 reported on the liquidation should be recalculated. I do not think that this would have been an appropriate remedy. The deductibility of the interest is an issue that is quite separate from the effect on the adjusted cost base of the shares of PDI of the contribution of capital or the payment of dividends. In the absence of a finding that the entire series of transactions was a sham one cannot ignore the legal effect under the Income Tax Act of each of the constituent elements.

In assessing the appellant in respect of the income of its predecessor PDL for the 1985 and 1986 taxation years the Minister of National Revenue disallowed as a deduction in computing income the amounts of $193,684 and $898,241 paid as interest to the Royal Bank of Canada. In the respondent's reply to the notice of appeal essentially four grounds were advanced in support of the assessment. They may be summarized as follows:

(a) that the interest was not interest on borrowed money "used for the purpose of earning income from a business or property" or an amount payable for property acquired for the purpose of gaining or producing income therefrom or for the purpose of gaining or producing income from a business within the meaning of subparagraphs 20(1)(c)(i) and (ii);

(b) that the deduction sought was in respect of a disbursement or expense made in respect of a transaction or operation that, if allowed, would unduly or artificially reduce the income" within the meaning of subsection 245(1);

(c) that the transactions or certain of them were shams or subterfuges;

(d) that PDI was a mere nominee or conduit of the appellant.

Counsel for the respondent abandoned the last two positions pleaded and based his case solely on paragraph 20(1)(c) and subsection 245(1).

The elements of the plan are relatively simple. They are:

(a) a borrowing of funds by the Canadian parent from a bank for a predetermined period at a specified interest rate;

(b) the insertion of those funds in the U.S. subsidiary as contributed capital;

(c) the investment thereof by the subsidiary in a term deposit at a specified interest rate (which it was known from the outset was lower than that paid on the borrowing) for the same term as the loan;

(d) the posting of the term deposit by the subsidiary with the lender as security for the parent's loan;

(e) the earning of interest by the subsidiary with no associated cost to the subsidiary;

(f) the absorption of the subsidiary's accumulated U.S. losses by the interest earned with the result that no U.S. tax is paid;

(g) the payment of a tax-free dividend to the parent by the subsidiary of the interest so earned;

(h) the transfer of the funds back to the parent by way of loan when the term deposit matured and the losses had been used up;

(i) the repayment to the bank of the parent's loan;

(j) the liquidation of the subsidiary and the disappearance of the loan to the parent;

(k) the deduction by the parent in computing its income of the interest on the borrowed funds.

Since the facts are clear and the fiscal objectives undisputed the question becomes essentially one of law. I shall endeavour to formulate it as follows:

Where a Canadian company borrows funds in Canada to contribute as capital to its U.S. subsidiary with the admitted ultimate object of utilizing losses sustained by the subsidiary and with no expectation of ever receiving a return that is equal to or greater than the interest it pays on the borrowed funds, is the interest that it pays, or any portion thereof, deductible?

In other words, does the plan work? By"work" I mean merely to achieve its stated fiscal objective.

For it to work four elements were necessary:

(a) there had to be no interest cost to the subsidiary of the funds that it invested in the term deposits;

(b) the interest paid by the Canadian parent had to be deductible in computing its income;

(c) the income from the term deposit earned by the subsidiary had to be free of U.S. tax.

(d) the dividends paid by the subsidiary to the parent had to be free of Canadian tax.

Artificiality—subsection 245(1)

I shall deal first with the argument under subsection 245(1) as it applied to 1985 and 1986. Subsection 245(1) was, prior to the enactment of the so-called general anti-avoidance rule now contained in the present subsection 245(1), sometimes used to counteract what the Minister conceived to be unacceptable tax avoidance. The Minister has been somewhat sparing in his use of the provision, preferring, it would seem, to rely upon other provisions of the Act or upon general broad principles. For example, in Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536, [1984] C.T.C. 294, 84 D.T.C. 6305 the profitable assets of one company were transferred to a related company to use up the latter's losses. It was argued that the transactions were incomplete, shams and without business purpose. The Supreme Court of Canada, in allowing the taxpayer's appeal, held that the absence of business purpose was no impediment to the effectiveness of the scheme, that the transaction was not a sham and that it was complete.

Although the Crown specifically refrained from relying upon section 137 (the predecessor to section 245) Estey, J. commented briefly on that section at page 579 (C.T.C. 316, D.T.C. 6323):

Where the facts reveal no bona fide business purpose for the transaction, section 137 may be found to be applicable depending upon all the circumstances of the case. It has no application here.

Since the Crown did not rely on section 137 the court did not elaborate upon the type of circumstances that would justify applying section 137 to a transaction lacking a business purpose. We are afforded, however, some guidance from a number of other decisions of the Supreme Court of Canada and the Federal Court of Appeal. Harris v. M.N.R., [1966] S.C.R. 489, [1966] C.T.C. 226, 66 D.T.C. 5189 involved a scheme under which a service station was leased for 25 years to an oil company and concurrently leased to the taxpayer for 200 years with an option to purchase at the end of the term. The taxpayer relied upon section 18 of the Income Tax Act, as it then read, to claim capital cost allowance on the aggregate of the rental payments over the 200 year term, less the fair market value of the land. The scheme, had it succeeded, would have resulted in the taxpayer, for an investment of $10,000, being able to claim capital cost allowance on a deemed capital cost of over $600,000. Cartwright, J., as he then was, after holding that the option contravened the rule against perpetuities, went on to observe at page 505 (C.T.C. 242, D.T.C. 5198) that the arrangement embodied in the scheme "would furnish an example of the very sort of “transaction or operation" at which subsection 137(1) is aimed”.

In Shulman v. M.N.R., 62 D.T.C. 1166, the Supreme Court of Canada, without written reasons, affirmed a decision of Ritchie, D.J. ([1961] C.T.C. 385, 61 D.T.C. 1213) which held that the use of a management company to which a lawyer paid management fees to administer his law practice artificially reduced his income. The management fees were disallowed as a deduction under subsection 137(1). Recent jurisprudence, such for example as Flemming Estate v. M.N.R., [1984] C.T.C. 352, 84 D.T.C. 6447 (F.C.A.), would not justify placing undue reliance on that decision today.

In Consolidated-Bathurst Ltd. v. The Queen, [1987] 1 C.T.C. 55, 87 D.T.C. 5001, the Federal Court of Appeal held that the deduction of premiums paid to an arm's-length insurer where that insurer reinsured the risks with the insured's offshore captive insurance company was prohibited under subsection 245(1) where the insured guaranteed the captive's potential obligations to the primary insurer, but not where it did not. In the former case, subsection 245(1) was held to be applicable because there was no shifting and distribution of risk and therefore no true insurance protection was obtained. Where no such guarantees were given the taxpayer's insurance arrangements were held not to be tainted by artificiality.

A recent and significant decision of the Federal Court of Appeal on artificiality is Canada v. Irving Oil Ltd., [1991] 1 C.T.C. 350, 91 D.T.C. 5106. In that case, as part of an obvious tax avoidance scheme, an offshore company was inserted between the domestic taxpayer's suppliers of crude oil and the taxpayer. The offshore company served no commercial purpose whatever. Ithad but one full-time employee, it never took possession of or insured the oil and its operating expenses were minimal. It took no part in the transportation of the oil and had title thereto only long enough to increase the price from that at which the appellant could buy from its Middle East suppliers to a figure that, it was found, was fair market value.

Although the Federal Court of Appeal disagreed with virtually all of the trial judge's conclusions, it held that the arrangement was not a sham (see Dominion Bridge Co. v. The Queen, [1977] C.T.C. 554, 71 D.T.C. 5367), and that the deduction, in computing the appellant's income of the amount by which the Bermuda company increased the price to the Canadian parent for the scintilla of time when it had legal title to the oil did not “ unduly or artificially” reduce the appellant's income. Leave to appeal to the Supreme Court of Canada was denied.

I find the observations of Mahoney, J., speaking for the Court, at pages 360-61 (D.T.C. 5114) particularly instructive:

In order to come within the terms of subsection 245(1), a transaction or operation must have the effect of unduly or artificially reducing income; the artificiality of the transaction or operation itself does not determine the issue. Heald, J.A., speaking for the Court in Spur Oil v. The Queen, [1981] C.T.C. 336, 81 D.T.C. 5168 (F.C.A.), at page 342 (D.T.C. 5173), said:

. . . the finding of artificiality in the transaction does not, per se, attract the prohibition set out in subsection 245(1) of the Income Tax Act. To be caught by that subsection, the expense or disbursement being impeached must result in an artificial or undue reduction of income."Undue" when used in this context should be given its dictionary meaning of "excessive". In light of the Crown’s concession . . . that under the Tepwin contract the appellant would be paying slightly less than fair market value, it cannot be said that the Tepwin contract and the Tepwin charge result in an excessive reduction of income. Turning now to artificial, the dictionary meaning when used in this context is, in my view, “simulated” or "fictitious". On the facts in this case, the reduction in the income of the appellant can, in no way, be said to be fictitious or simulated.

It is likewise here. Since the respondent paid Irvcal fair market value, it cannot be said that payment resulted in an excessive reduction of income. There was nothing fictitious or simulated in the reduction of the respondent's income as a result of paying Irvcal 66¢ more per barrel of crude than the crude cost Irvcal. It was very real.

The ratio in Spur Oil, supra was reached on the basis that the result of a nonarm's length transaction was the result that would have been reached at arm's length. The appellant's submission that the fact, as found by the trial judge, that the respondent and Irvcal dealt at arm's length distinguishes this case from Spur Oil is therefore singularly unpersuasive.

Conclusion

The Supreme Court of Canada’s decision in Stubart, supra reaffirmed that it remains the law of Canada that

Every man is entitled if he can to order his affairs so as that the tax attaching under the appropriate Acts is less than it otherwise would be. If he succeeds in ordering them so as to secure this result, then, however unappreciative the Commissioners of Inland Revenue or his fellow taxpayers may be of his ingenuity, he cannot be compelled to pay an increased tax [/.R.C. v. Duke of Westminster, [1936] 1 A.C. 1 at pages 19-20].

On the facts as found herein, it is my opinion that the tax avoidance scheme contrived in the present case did not offend the Income Tax Act.

It is fair to say that artificiality is in the eye of the beholder, and where one draws the line between “acceptable” and "unacceptable" tax avoidance schemes is a matter of perception. In that determination the fact that the scheme may have been predominantly or exclusively fiscally motivated plays a minor or even a non-existent role. (See also: A/berta and Southern Gas Co. v. The Queen, [1976] C.T.C. 639, 76 D.T.C. 6362, at page 651 (D.T.C. 6369-70 (F.C.T.D.); aff'd [1977] C.T.C. 388, 77 D.T.C. 5244 (F.C.A.); aff’d [1979] 1 S.C.R. 36, [1978] C.T.C. 780, 78 D.T.C. 6566.) What is of far greater importance is whether the scheme falls within accepted norms of commercial reality. The 200-year lease option in Harris on the face of it was not within those bounds. Similarly, in Consolidated-Bathurst, a guarantee by the insured of the reinsurer's obligations to the primary insurer was held not to be within ordinary principles of commercial usage within the insurance industry. In Irving Oil the purchase of crude oil from a subsidiary at a price that was found by the trial judge to be fair market value appeared to the Federal Court of Appeal to offend no principles of commercial normality.

Wherein, then, lies the artificiality in this case? The transactions with the Royal Bank were at arm's length. The rate of interest charged was not excessive

— indeed it may have been somewhat lower than that charged domestically. The income produced by the investment of the funds in a term deposit arose out of a anormal commercial act. There was nothing unusual about the payment of dividends. The documentation necessary to accomplish each of the steps was prepared, executed and delivered as required and the transactions were duly completed in accordance with the documents. They were real transactions. The artificiality, if I understand the respondent's argument correctly, must consist in the overall objective of utilizing the U.S. subsidiary's losses in Canada and the attainment of that end by borrowing at a rate that was higher than the anticipated return, all in accordance with a prearranged plan.

Considered separately neither of these elements justifies a disallowance of the interest paid under subsection 245(1). The tax considerations that motivated the arrangement by itself do not by themselves bring it within the ambit of subsection 245(1). [1] The borrowing at a rate that does not and cannot yield an economic return as a means of achieving a predetermined economic result is in itself not artificial. To hold that this scheme failed for artificiality would be to ignore the decision of the Federal Court of Appeal in Irving, If the Irving scheme was not artificial this one cannot be.

One final observation must be made. We have here a series of interrelated transactions. The Crown has challenged under subsection 245(1) only one aspect of the entire arrangement, the deduction of interest, on the basis that it results in an artificial or undue reduction of the appellant's income. Yet it has chosen to leave intact the consequences of all but one of the component parts. Either the whole structure falls or it does not. It cannot be dismembered piecemeal. In any fiscally motivated scheme, if no sham is involved, there must necessarily be legally effective steps that have specific tax consequences. The tax results of each of those steps that forms an integral part of the entire scheme must be respected unless the Minister is prepared to say that the scheme as a whole fails.

I have concluded that the deduction of the interest is not prohibited by subsection 245(1).

”. . . Used for the purpose of earning income from a business or property"

— paragraph 20(1)(c)

The appellant’s claim to deduct the interest is based upon paragraph 20(1)(c), the relevant portion of which reads as follows:

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:

(c) 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),

(ii) an amount payable for property acquired for the purpose of gaining or producing income therefrom or for the purpose of gaining or producing income from a business (other than property the income from which would be exempt or property that is an interest in a life insurance policy),

or a reasonable amount in respect thereof, whichever is the lesser.

The respondent's denial of deductibility is based on the position that the borrowed money upon which the interest was paid was not “used for the purpose of earning income from a business or property" within subparagraph (i) nor was it interest on

an amount payable for property acquired for the purpose of gaining or producing income therefrom or for the purpose of gaining or producing income from a business

within the meaning of subparagraph (ii).

I agree with the respondent's position that subparagraph (ii) has no application. The interest on the money borrowed from the bank was not interest on an amount payable for property.

What then was the purpose for which the borrowed money was used? To this question a number of answers were given. Counsel for the appellant stated that the funds were used for the purpose of earning dividend income. Counsel for the respondent contended that I should not focus on the "purpose" of the borrowing but, as directed by the Supreme Court in The Queen v. Bronfman Trust, [19871 1 S.C.R. 32, [1987] 1 C.T.C. 117, 87 D.T.C. 5059, on the "direct" use of funds. Indeed, it is the purpose of the use, not the purpose of the borrowing, to which the statute directs us. In fact the purpose of the borrowing and the use of the funds are identical. They were used for the very purpose for which they were borrowed. Accordingly the distinction is not meaningful. The respondent's position was that the use to which the borrowed money was put was to contribute capital to PDI — a use that in itself produced no income — and that, based on Canada Safeway Ltd. v. M.N.R., [1957] S.C.R. 717, [1957] C.T.C. 335, 57 D.T.C. 1239, I should not look to the "remote" or "indirect" purpose of earning dividend income.

Both the appellant's and the respondent's characterizations of the purpose for which the funds were used have a certain superficial correctness, but I think they are both based on a logical fallacy in that they attribute to one event in the series a purpose based upon the immediately subsequent event. The true purpose is a broader one that subsumes all of the subordinate and incidental links in the chain. The overriding ultimate economic purpose for which the borrowed funds were used was to permit the U.S. losses of PDI to be, in effect, imported into Canada and deducted in computing PDL's income.

In light of the strong reliance placed by the respondent upon the decision of the Supreme Court of Canada in Canada Safeway it is appropriate that I deal first with it. It does not support the respondent's position. It involved a claim to deduct interest expense incurred in 1947, 1948 and 1949. The appellant, which operated grocery stores, borrowed money with which to acquire the shares of a distributor of grocery products with which it had business dealings. It sought to deduct the interest incurred in 1947 and 1948 under paragraph 5(1)(b) of the Income War Tax Act as interest on "borrowed capital used in the business to earn the income”. Its claim for 1949 was based on paragraph 11(1)(c) of the Income Tax Act, S.C. 1947-8 c. 52. In analyzing the effect of this decision it is important to observe that the contention was that the ownership of the shares of the distributor would in some way enhance the income earning potential of the appellant's own business. It was not suggested, nor could it have been, that the use was merely the acquisition of shares that produced dividends. In 1947 and 1948 intercorporate dividends were, under section 4 of the Income War Tax Act, “not liable to taxation” and expenses to earn such "non-taxable income" were, under subsection 6(5), not allowed as a deduction. That situation continued into 1949 when paragraph 11(1)(c) of the Income Tax Act (now 20(1)(c)) superseded paragraph 5(1)(b) of the Income War Tax Act. Paragraph 11(1)(c), as does present paragraph 20(1)(c), denied a deduction for interest on borrowed money used to earn income from property the income from which would be exempt. "Exempt income” as defined in section 139 included intercorporate dividends that were deductible under section 27 in computing taxable income. It was not until tax reform in 1972 that the definition of exempt income was changed specifically to exclude a dividend on a share.

The error in relying upon Canada Safeway to deny the deductibility of interest on borrowed money used to purchase shares or contribute capital to a corporation is this: the purpose relied on in that case by the appellant was not the earning of dividends. If that were the purpose alleged the deduction was prohibited in any event by subsection 6(5) of the Income War Tax Act and, in 1949, the words in parentheses in paragraph 11(1)(c), which denied a deduction for interest expense incurred to earn exempt income. The purpose alleged was the effect on the appellant's own business of owning the shares of the subsidiary. It was this purpose that was rejected by the Supreme Court of Canada as being too remote and indirect to bring the deduction within the restrictive wording of paragraph 5(1)(b).

Under present legislation, and in particular the definition of exempt income in section 248, dividends are not "exempt income". The decision in Canada Safeway is not an authority for the proposition that an expenditure that has as its purpose the receipt of dividends — such for example as a contribution ofcapital to a subsidiary or the acquisition of shares — is a purpose that is too remote and indirect to permit the interest on borrowed money used for that purpose to be deducted.

In Bronfman, interest on money borrowed by a trust to make capital allocations to a beneficiary was held to be non-deductible. The rationalization advanced by the trust was that the borrowing was done to protect the capital assets of the trust that would otherwise have had to be sold to make the distribution. The assets that were allegedly being protected produced income that was but a small fraction of the interest expense deducted.

Although the wide-ranging observations in Bronfman are cited in support of many propositions [2] the basis of the decision is found in three paragraphs on pages 52-53 (C.T.C. 128-29, D.T.C. 5067):

This does not mean, however, that a deduction such as the interest deduction in subparagraph 20(1)(c)(i), which by its very text is made available to the taxpayer in limited circumstances, is suddenly to lose all its strictures. It is not lightly to be assumed that an actual and direct use of borrowed money is any less real than the abstract and remote indirect uses which have, on occasion, been advanced by taxpayers in an effort to achieve a favourable characterization. In particular, I believe that despite the fact that it can be characterized as indirectly preserving income, borrowing money for an ineligible direct purpose ought not entitle a taxpayer to deduct interest payments.

The taxpayer in such a situation has doubly reduced his or her long-run income-earning capacity: first, by expending capital in a manner that does not produce taxable income; and second, by incurring debt financing charges. The taxpayer, of course, has a right to spend money in ways which cannot reasonably be expected to generate taxable income but if the taxpayer chooses to do so, he or she cannot expect any advantageous treatment by the tax assessor. In my view, the text of the Act requires tracing the use of borrowed funds to a specific eligible use, its obviously restricted purpose being the encouragement of taxpayers to augment their income-producing potential. This, in my view, precludes the allowance of a deduction for interest paid on borrowed funds which indirectly preserve incomeearning property but which are not directly “used for the purpose of earning income from . . . property”.

Even if there are exceptional circumstances in which, on a real appreciation of a taxpayer's transactions, it might be appropriate to allow the taxpayer to deduct interest on funds borrowed for an ineligible use because of an indirect effect on the taxpayer's income-earning capacity, I am satisfied that those circumstances are not presented in the case before us. It seems to me that, at the very least, the taxpayer must satisfy the Court that his or her bona fide purpose in using the funds was to earn income. In contrast to what appears to be the case in TransPrairie, the facts in the present case fall far short of such a showing. Indeed, it is of more than passing interest that the assets which were preserved tor a brief period of time yielded a return which grossly fell short of the interest costs on the borrowed money. In 1970, the interest costs on the $2,200,000 of loans amounted to over $110,000 while the return from an average $2,200,000 of trust assets (the amount of capital"preserved") was less than $10,000. The taxpayer cannot point to any reasonable expectation that the income yield from the trust's investment portfolio as a whole, or indeed from any single asset, would exceed the interest payable on a like amount of debt. The fact that the loan may have prevented capital losses cannot assist the taxpayer in obtaining a deduction from income, which is limited to use of borrowed money for the purpose of earning income.

What, then, is the "direct" use to which the borrowed funds were put here? The direct and immediate use was the injection of capital into a subsidiary with the necessary and intended consequence that the subsidiary should earn interest income from term deposits from which it could pay dividends. The earning of dividend income cannot, however, in my opinion, be said to be the real purpose of the use of the borrowed funds. Theoretically one might, in a connected series of events leading to a predetermined conclusion, postulate as [to] the purpose of each event in the sequence the achievement of the result that immediately follows but in determining the “purpose” of the use of borrowed funds within the meaning of paragraph 20(1)(c) the court is faced with practical considerations with which the pure theorist is not concerned. That purpose — and it is a practical and real one, and in no way remote, fanciful or indirect — is the importation of the losses from the U.S. This case is not the converse of Bronfman. The vague purpose of protecting assets that produced virtually no income was patently subservient to the direct and uneconomic purpose of distributing capital to a beneficiary of the trust. Here the immediate step of investing in a subsidiary that in accordance with the scheme must necessarily pay dividends was not the real purpose of the use of the funds. The earning of interest income by PDI and the payment by it of dividends to PDL were integral but subservient and incidental steps to the real objective that lay behind the implementation of the plan. The amount of dividends, albeit deductible in computing taxable income, and based upon the interest from the term deposits, was less than the interest paid to the Royal Bank. It is true that the overall economic result, if all of the elements of the plan work, is a net gain to the appellant, but this type of gain is not from the production of income but from a reduction of taxes otherwise payable in Canada. I am cognizant of the fact that the dividends, although deductible in computing taxable income, are nonetheless income. It is, however, this feature of our Canadian tax system whereby such dividends are deductible in computing taxable income that gives to the plan its apparent economic viability.

If I am wrong in distinguishing between intermediate or subordinate results and ultimate economic objectives I must deal with a further submission made by the respondent. Counsel for the Minister contends that even if the purpose was the earning of dividend income this is of no assistance to the appellant because a taxpayer's"income" from a business or property is stated in section 9 to be “subject to this Part . . . his profit therefrom" for the year. From this wording, counsel suggests that any expenditure which necessarily exceeds the income that it is designed to produce must be denied under paragraph 18(1)(a) or, if it is interest, under paragraph 20(1)(c) because it could not conceivably be expended to earn income" in the sense of profit.

This contention is based upon an assumption that section 9 contains a definition of income from a business or property that must be applied throughout the Income Tax Act unless a contrary intention appears. (See section 15 of the Interpretation Act, R.S.C. 1970, c. 1-23, section 1.) I do not think that Parliament intended section 9 to be a definition of income. The use of the word "is", as opposed to "means", the word habitually used in definitions, implies in my view that Parliament was declaring, for greater certainty, a principle that has been entrenched in income tax law for over a century, that the income upon which tax is imposed is the balance of gain over loss. In Lawless v. Sullivan (1881), 6 App. Cas. 373, the Privy Council, in dealing with a New Brunswick statute that imposed a tax on "income", stated at pages 383-84:

Their Lordships have come to the conclusion, upon consideration of the Act in question, that there is nothing in the enactment imposing the tax, nor in the context, which should induce them to construe the word” income,” when applied to the income of a commercial business for a year, otherwise than in its natural and commonly accepted sense, as the balance of gain over loss, and consequently they are of opinion that where no such gain has been made in the fiscal year, there is no income or fund which is capable of being assessed.

That the word income" is susceptible of two meanings —" net income” or "gross income” — is obvious. It was the subject of a lengthy discussion in the High Court of Australia in Bartlam v. Union Trustee Co. of Australia Ltd., [1946] A.L.R. 162. Latham, C.J. observed at page 164:

The Court was referred, on the one hand to Lawless v. Sullivan (1881), 6 App. Cas. 373, where it was said that the natural meaning of the word "income" was the gain, if any, resulting from the balance of profits and losses of the business in a year; and, on the other hand, to R. v. Commissioners of the Port of Southampton (1870), L.R. 4 H.L. 449, where it was said that “income is that which comes in, not that "which comes in less an outgoing." These cases, taken together, show that the word “income” is ambiguous. It may mean either net income or gross income, according to the context — and there will then sometimes be room for argument as to how net income (or gross income) is to be ascertained. Two men referring to the same state of facts might use the word in quite different senses. One man might say that he had a large income in a given year, but that all his income and more went in meeting expenses and losses. Another man might describe the same facts by saying that he had no income at all in that year, because he made a loss on the year's transactions. In each case the context shows in what sense the word "income" is used. In the present case the words of the section show, in my opinion, that" income received" means all receipts other than receipts on account of capital.

Dixon, J. (as he then was) commented as well, at pages 169 to 171 of the report on the ambiguity of the word. It may be that this essential ambiguity impelled Parliament in the 1948 Income Tax Act to affirm that the income that is subjected to tax is net income and not gross receipts. This does not however amount to a definition applicable for all purposes of the Act. Had that been the intention Parliament would have had no difficulty in finding words appropriate to express that intention. The attempt to define income found in section 3 of the Income War Tax Act was abandoned in the 1948 Act.

The most compelling authority for the conclusion that section 9 is not a definition and that in the Act income may mean gross or net income depend- ing upon the context in which it is used, is a decision of the Supreme Court of Canada in Interprovincial Pipe Line Co. v. M.N.R., [1959] S.C.R. 763, [1959] C.T.C. 339,59 D.T.C. 1229. The question was whether the appellant was entitled to a foreign tax credit under subsection 38(1) of the 1948 Income Tax Act for 1950 to 1952 and under subsection 41(1) of the Income Tax Act as it applied to 1953 and 1954 in respect of withholding tax that it paid to the United States on interest paid to it. The claim was denied on the basis that although it received interest from U.S. sources it had no profit therefrom because it paid interest on its own borrowings equal to or greater than its interest receipts. Judson, J. said at pages 766-68 (C.T.C. 341-44, D.T.C. 30-1231):

The United States tax credit was disallowed because the Minister ruled that Interprovincial had no profit from the receipts of interest from United States sources, having paid interest on its own borrowings to an amount equal to or in excess of these receipts and these interest payments having been recognized as deductible expenses. The right to a tax credit was therefore made to depend upon the existence of a profit after setting off one item against the other and the basis for the decision was the interpretation of section 4 of the Income Tax Act, which provides as follows:

24. Subject to the other provisions of this Part, income for a taxation year from a business or property is the profit therefrom for the year.

The reasoning is that section 4 compels one to read the word "income" as meaning "profit" in section 38(1) of the Act. This is indicated very clearly in the following paragraph from the reasons of the learned trial judge:

By section 4 of The Income Tax Act, however, income for a taxation year from a business or property is declared, subject to the other provisions of Part 1, to be the profit therefrom for the year and, since the source of the interest in question on which tax was paid to the United States was clearly either a business or property and no other provision of Part 1 declares that interest earnings are to be brought into the computation of income or taxed on any other basis, it follows, in my opinion, that what is to be regarded for the purposes of Part 1 of the Income Tax Act as the income from such business or property is not the gross amount of such interest for each year but the profit from such property or business for the year. If there is no profit from a business or property for any year, there is no income therefrom for that year. Section 38(1) of the Income Tax Act can thus afford a tax credit only in a year in which the appellant had a profit for the year from the business or property in the United States from which the interest in question flowed.

In my respectful opinion, there is error here in stating that "no other provision of Part I declares that interest earnings are to be brought into the computation of income or taxed on any other basis” for such a finding ignores the imperative provisions of paragraph 6(b) of the Act. In my opinion it is the payment of the withholding tax of 15 per cent, in the United States on this interest receipt — not profit — an interest receipt which the taxpayer is required to bring into the computation of income by paragraph 6(b), which gives the right to the foreign tax deduction under subsection 38(1).

The appellant is a Canadian company. It did pay a 15 per cent withholding tax to the United States on income from sources therein. To deprive the appellant of the right to the tax deduction it is necessary to substitute for "on his income from sources therein” the words "on his profits from sources therein" and I do not think that section 4 affords the statutory basis for such a substitution.

First, section 4 is expressly made subject to the other provisions of Part I of the Act. One of these, affecting the matter, is paragraph 6(b), which provides:

6. Without restricting the generality of section 3, there shall be included in computing the income of a taxpayer for a taxation year

(b) amounts received in the year or receivable in the year (depending upon the method regularly followed by the taxpayer in computing his profit) as interest or on account or in lieu of payment of, or in satisfaction of interest; Paragraph 6(b) imperatively requires that the whole of the interest from United States sources must be brought into account in the computation of income and on the other side of the account there is a deduction that must be allowed under paragraph 11(1)(c) for interest on “borrowed money used for the purpose of earning income from a business or property.” This, in fact, is what has actually happened. The full interest receipt has been brought into account and the full interest payment has been claimed and allowed as a deduction without allocation, but for the purpose of denying the appellant the right to the tax credit under subsection 38(1), a subsidiary calculation has been made within this framework for the purpose of showing that when the allocable expense is set against the United States interest receipt, there is no profit on this branch of the appellant's activity and, consequently, no right to a tax credit.

I can see no basis for any allocation of the appellant's borrowings to its investment in its subsidiary for the purpose of producing this result under subsection 38(1). The appellant’s borrowings and the interest paid thereon were related to the business as a whole and no part of the borrowings and the interest paid thereon can be segregated and attributed to the investment in the subsidiary. The interest paid by the appellant to its own bondholders was, under paragraph 11(1)(c), a deduction given to the appellant for the purpose of computing its income from all sources. Sections 3 and 4 of the Act do not require a separate computation of income from each source for the taxpayer is subject to tax on income from all sources. The deduction against income given by paragraph 11(1)(c) is attributable to all sources of income and there is no authority to break it up and relate various parts of the deduction to various sources. For this reason I do not regard the interest paid and claimed and allowed as a deduction, as being related to the source of the United States interest receipt in this case, and consequently, paragraph 139(1)(az), formerly paragraph 127(1)(av) of the 1948 Income Tax Act, does not, in my opinion, authorize the allocation which the Minister has made in this case.

It should be noted that the direct attribution of the interest on the borrowings to the investment in PDI is possible as a factual matter in this case whereas in Interprovincial Pipe Line no such factual nexus was evident. This consideration does not alter the conclusion that the Supreme Court of Canada did not interpret section 4 (now section 9) as a definition section or the word income to mean profit in the circumstances of that case.

Locke, J. stated at page 774 (C.T.C. 348-49, D.T.C. 1234):

The judgment appealed from has interpreted the word income” in these subsections as if it read "profit" and, admittedly, if that interpretation is correct, no profit resulted to the appellant from the receipt of these moneys, since the annual cost to it of the funds used in the purchase of the securities exceeded the amounts paid in the United States.

I can find no support for this interpretation either in section 4 or elsewhere in either Act. The word income" is used rather loosely in both of these statutes. The attempt to define "income" made in subsection 3(1) of the Income War Tax Act was not repeated in either. Thus, in section 3 the income of a taxpayer is stated to include all income, meaning all receipts from, inter alia, all businesses and property. In section 4, however, income from a business is said to be the profit therefrom for the year, in this sense meaning the taxable income. The deductions allowed are not deductions from income in the sense that that expression is used in section 3 but from the tax payable in Canada after all of the receipts from the business have been brought into account, as required.

He was obviously not using the expression "taxable income” in the technical sense in which it is used in Division C of Part 1. His reasons however provide ample support, along with those of Judson, J. for my rejection of the premise upon which the respondent's argument is based that income must necessarily mean "profit" in the phrase "for the purpose of earning income" in paragraph

Accordingly I am unable to accept the interpretation of section 9 advanced by counsel for the respondent. To reject the appellant's claim on this basis would mean that if the interest earned on the term deposits, and therefore the dividends, were slightly more than the interest paid on the bank loan, the entire interest paid would be deductible, whereas if the return were fractionally less, nothing would be deductible. To base the disposition of this case on such a technicality, without considering the overriding ultimate purpose, is unrealistic. Indeed, Dickson, J. stated in Bronfman at pages 52-53 (C.T.C. 128, D.T.C. 5066-67):

I acknowledge, however, that just as there has been a recent trend away from strict construction of taxation statutes . . . so too has the recent trend in tax cases been towards attempting to ascertain the true commercial and practical nature of the taxpayer's transactions. There has been, in this country and elsewhere, a movement away from tests based on the form of transactions and towards tests based on what Lord Pearce has referred to as a "common sense appreciation of all the guiding features" of the events in question. . . .

This is, I believe, a laudable trend provided it is consistent with the text and purposes of the taxation statute. Assessment of taxpayers' transactions with an eye to commercial and economic realities, rather than juristic classification of form, may help to avoid the inequity of tax liability being dependent upon the taxpayer's sophistication at manipulating a sequence of events to achieve a patina of compliance with the apparent prerequisites for a tax deduction.

Moreover the interpretation contended for by the respondent in my view attributes to section 9 an effect that ignores its purpose. Its purpose is not to define income. Rather it emphasizes that in the computation of income one must apply, subject to the Act, "ordinary principles of commercial accounting so far as applicable and in conformity with the rules of the Income Tax Act. [See Whimster & Co. v. C.I.R., 12 Tax Cases 813, cited in M.N.R. v. Anaconda American Brass Ltd., [1955] C.T.C. 311, 55 D.T.C. 1220 (P.C.) at page 319 (D.T.C. 1224).] Interest on money that is borrowed to invest in common shares, or property, or a business or corporation is deductible because it is laid out to earn amounts that must be included in the computation of income. Amounts of income such as dividends which must be included in income under paragraphs 12(1)(j) and (k) do not cease to be income merely because they are exceeded by the cost of their production. [4] In the case of money borrowed to

1 was referred as well to a decision of the Supreme Court of Canada in Deputy Minister of Revenue (Quebec) v. Lipson, [1979] 1 S.C.R. 833, [1979] C.T.C. 247 where a group of shareholders leased an apartment from their own company in order to take advantage of losses that the company could not absorb. It is not clear from the judgment of Pigeon, J. whether what was disallowed was the entire expenditure by the taxpayers or their net loss. Pigeon, J. stated at page 839 (C.T.C. 250):

. . .it is the entire loss which is not deductible, because it was not an expense incurred for the purpose of gaining income. . . .

[Emphasis added.]

Pigeon, J. added that for an expense to be deductible it must be incurred to earn a profit and that" the actual purpose of the operation was not to make a profit but to put money into the company by incurring a loss to its benefit”. The case bears a certain superficial resemblance to this one, but it was not dealing with the situation in which amounts of income were in fact produced as part of the scheme and were specifically required to be included in income.

invest by means of a contribution of capital in a corporation of which the taxpayer owns all of the shares, the purpose is generally and in the absence of some other overriding purpose such as we have here to earn income from property in the form of dividends or increased dividends generated from income earned by the subsidiary with the additional capital. [5] It is deductible even if it fails to achieve that object.

I recognize that it might be argued that where money is borrowed to invest in a manner that it is acknowledged from the outset could not under any circumstances ever produce income or deemed income equal to or greater than the interest expense, it would be unreasonable to require both the inclusion in income of the gross revenues produced and a recognition of all of the other incidents of that inclusion, (such as the erosion of the adjusted cost base of the shares, as is the case here), and yet deny the deduction of any part of the interest which is the cost of earning those revenues. The corollary would be that it would be equally unreasonable to permit the deduction of interest exceeding the income that it is predetermined will be earned, on the basis that such an interpretation of the Income Tax Act would lead to an absurdity and should be avoided. [6] The result of this approach would be that it would be "reasonable" to allow a deduction of the interest up to the amount of the dividends anticipated and actually received in accordance with the concluding words in paragraph 20(1)(c)"or a reasonable amount in respect thereof, whichever is the lesser”.

I have decided, however, that although this approach is superficially attractive it is not in accordance with the scheme of the Income Tax Act or its object and spirit. Moreover it ignores the true purpose for which the funds were used.

The true purpose for which the borrowed money was used was to implement a plan to absorb into the Canadian parent's income the losses of a foreign subsidiary. That result is not contemplated by the Canadian income tax system and it is not consistent with the scheme of the Act which contemplates the separation for fiscal purposes of the profits and losses of separate corporate entities. As Mr. Chambers observed in his argument, the consolidation for tax purposes of the financial results of domestic companies is not contemplated by our Act and this holds true a fortiori in the case of foreign subsidiaries. An arrangement that seeks in effect to do so runs counter to a fundamental principle that is firmly entrenched in our Act and accordingly is not in accordance with the object and spirit of the Income Tax Act as a whole. The approach which I have adopted in attempting to resolve this difficult question is, I believe, consistent with principles enunciated in two cases, Trans-Canada Investment Corp. v. M.N.R., [1953] C.T.C. 353, 53 D.T.C. 1227; aff'd [1956] S.C.R. 384, [1955] C.T.C. 150, 55 D.T.C. 1191 and Highway Sawmills Ltd. v. M.N.R., [1966] S.C.R. 384, [1966] C.T.C. 150, 66 D.T.C. 5116. In the Exchequer Court decision in Trans-Canada Investment Corp., Cameron, J. said at page 360 (D.T.C. 1231):

I agree that it is possible to interpret the language of the section as requiring that the dividend must have been received directly from the paying corporation. But in my view, there is another interpretation that may be put upon it, an interpretation which I think is more consonant with the intention of Parliament as I deem it to be from the language itself.

In Caledonian Railway v. North British Railway (1881), 6 App. Cas. 114, Lord Selborne said at page 122:

The more literal construction of a statute ought not to prevail if it is opposed to the intentions of the Legislature as apparent by the statute, and if the words are sufficiently flexible to admit of some other construction by which the intention can be better effectuated.

Again, in Shannon Realties v. St. Michel, [1924] App. Cas. 192, it was stated that if the words used are ambiguous, the Court should choose an interpretation which will be consistent with the smooth working of the system which the statute purports to be regulating.

In the same vein Cartwright, J., as he then was, stated in Highway Sawmills at page 393 (C.T.C. 157-58, D.T.C. 5120):

The answer to the question what tax is payable in any given circumstances depends, of course, upon the words of the legislation imposing it. Where the meaning of those words is difficult to ascertain it may be of assistance to consider which of two constructions contended for brings about a result which conforms to the apparent scheme of the legislation.

Interest on borrowed money is deductible to the extent that the money is used for the purpose of earning income from a business or property. The absorption of business losses of a foreign subsidiary is unquestionably a legitimate objective. Its overall purpose is to increase the net worth of the corporate group as a whole. This is an entirely commendable business purpose and any chief financial officer who failed to try to do so would not be doing his or her job. It is not, however, a purpose that falls within paragraph 20(1)(c) as a "purpose of earning income”. Accumulated business losses of domestic subsidiaries may be absorbed by Canadian parent companies by winding the subsidiary up into the parent or amalgamating it with a related company with a profitable business. Section 87, 88 and 111 contain detailed rules regulating the extent to which this can be done. No such procedures are available in the case of foreign affiliates.

I was referred to a substantial body of evidence of the Department of National Revenue's administrative practice in permitting procedures similar to those involved here that would allow Canadian companies to take advantage of losses of other related Canadian companies. [7] These practices make a certain amount of practical sense insofar as they are confined to Canadian companies. The rationale for what is possibly an administrative concession may be that the same result could be achieved by winding up or amalgamating the loss com- pany and utilizing its losses. [8] This administrative rationale could not justify a similar concession in the case of a foreign affiliate with accumulated losses because the alternative procedures under sections 87 and 88 that would permit the parent's utilization of the losses are simply not available. I do not criticize the Department's practices in this regard, but they cannot determine the result in this case.

My conclusion is therefore that the interest paid on the bank loan was not interest on borrowed money used for the purpose of earning income from a business or property.

The appeal is dismissed with costs.

Appeal dismissed.