Grenier v. Minister of National Revenue, [1998] 3 CTC 243, [1998] DTC 6439

Pinard J.:

This is an appeal from a decision of the Tax Court of Canada dated January 21, 1992, allowing in part the appeal of the defendant Pierre Grenier relating to an assessment made under the Income Tax Act (the “Act”) for his 1987 taxation year, by allowing the deduction of interest paid on part of a loan he took out on March 24, 1986.

The following facts were admitted by the parties expressly and verbatim:

1. On July 5, 1985, the defendant was one of the shareholders of Albi (1980) Inc. (“Albi”), a corporation operating a Mazda automobile business in Mascouche, Quebec.

2. At that time the defendant resided at 306 rue Montcalm, Rosemère, Quebec.

3. Thereafter, the defendant also became the principal shareholder of 144946 Canada Inc., operating under the business name Argus Mazda (“Argus Mazda”), which was to operate a Mazda automobile business in Hull, Quebec, after the defendant’s anticipated sale of his Albi shares.

4. Argus Mazda was to be financed in part by the bank, but the bank demanded an investment by the defendant as an advance to the company.

5. On July 5, 1985, the defendant obtained a loan of $65,625 from the National Bank of Canada, secured by a hypothec on the defendant’s principal residence at 306 rue Montcalm, Rosemère, Quebec.

6. The defendant advanced the $65,625 to Argus Mazda as a director’s advance, as reflected in the financial statements of Argus Mazda for its fiscal years ending on August 31, 1985, and August 31, 1987, respectively.

7. On August 2, 1985, the defendant sold the shares he owned in Albi to Gestion Devault Inc., for the sum of $112,500.

8. Out of the proceeds of sale of the Albi shares, the defendant advanced $90,194 to Argus Mazda as a director’s advance, as reflected in the financial statements of Argus Mazda for its fiscal years ending on August 31, 1985, August 31, 1986 and August 31, 1987, respectively, which meant that the defendant had advanced a total of $155,844, inter alia, to Argus Mazda, composed of $65,625 from the hypothecary loan on July 5, 1985 (see paragraph 5 supra) and the $90,194 from the proceeds of sale of the Albi shares J [1]

9. The advances by the defendant to the company totalling $155,844 ($65,650 and $90,194) were interest-free and had no repayment terms.

10 Argus Mazda commenced its business activities in September 1985, on Saint-Joseph Boulevard in Hull, Quebec.

11. Because the defendant’s new place of work was in Hull, the defendant sold his residence on rue Montcalm in Rosemère on April 30, 1986, for $110,000.

12. At the same time, and out of the sale price, the hypothecary loan taken out on July 5, 1985, was repaid in full.

13. On May 14, 1986, the National Bank of Canada issued a discharge deed to the defendant concerning the repayment of the loan of July 5, 1985.

14. In the meantime, on March 24, 1986, the defendant had obtained a loan from the Royal Bank of Canada in the amount of $151,700 to purchase an property at 22 rue Méditerranée in Gatineau, Quebec, where construction on the building was under way. The sale contract provided that this money would be paid to the defendant on May 1, 1986.

15. By deed of sale dated April 15, 1986, the defendant purchased the property at 22 rue Méditerranée in Gatineau, Quebec, for $167,361.84, and assigned the proceeds of the loan obtained on March 24, 1986 ($151,700), which was to be paid to him on May 1, 1986, to the vendor.

16. The difference between the purchase price for the house in Gatineau, $167,361.84, and the hypothec of $151,700 was paid by the defendant using the part of the proceeds of the sale of the Albi shares that he had not advanced to Argus Mazda.

17. Argus Mazda was still indebted to the defendant for the $65,625 advance throughout the defendant’s 1987 taxation year, notwithstanding the fact that the defendant had repaid the hypothecary debt in the same amount with which the Rosemère residence had been charged.

18. Since May 1, 1986, the immovable at 22 rue Méditerranée in Gatineau has been the defendant’s principal residence.

19. During his 1987 taxation year, the defendant paid $15,360.32 to the Royal Bank of Canada as interest on the loan taken out on March 24, 1986.

20. For his 1987 taxation year, the defendant claimed a deduction for the $15,360.32 paid to the Royal Bank of Canada as interest on the loan taken out on March 24, 1986.

21. By notice of reassessment dated September 13, 1989, the Minister of National Revenue denied that deduction on the ground that the $15,360.32 had not been paid pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from a business or property, as set out in paragraph 20(1 )(c) of the Income Tax Act.

22. On September 26, 1989, the defendant filed a notice of objection to the assessment referred to in the preceding paragraph.

23. By notice of confirmation dated March 7, 1990, the Minister of National Revenue confirmed the assessment of September 13, 1989. 24. The defendant filed an appeal to the Tax Court of Canada on June 8, 1990.

25. On January 21, 1992, the Tax Court of Canada allowed the defendant’s appeal in part; it allowed the deduction of the interest paid on $65,625, part of the loan taken out on March 24, 1986.

26. The subject matter of these proceedings is the deductibility of the interest paid on the $65,625, which comprises part of the amount borrowed on March 24, 1986.

In addition to agreeing that the questions of fact in this action are limited to the facts set out supra, the parties consented to having the only documents in evidence be those that form part of [translation] APPENDIX A which is an integral part of the [translation] “Agreement as to the facts”.

The Issue

The only issue is therefore whether the interest paid by the defendant on a figure of some $65,625, comprising part of the $151,700 that he borrowed on March 24, 1986, may be deducted from his taxable income.

Analysis

The relevant provisions of the Income Tax Act are as follows:

Section 18: General limitations.

(1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(a) General limitation — an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property;

Section 20: Deduction permitted in computing income from business or property.

(1) Notwithstanding paragraphs 18(1)(a), (b) and (A), 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 be regarded as applicable thereto:

(c) Interest — 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 as 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),

(3) Idem. For greater certainty, it is hereby declared that were a taxpayer has used borrowed money

(a) to repay money previously borrowed;

(b) to pay an amount payable for property described in subparagraph (l)(c)(ii) previously acquired,

subject to subsection 20.1(6), the borrowed money shall, for the purposes of paragraphs 1(c), (e) and (e.1), subsections 20.1(1) and (2), section 21 and subparagraph 95(2)(a)(ii) and for the purpose of paragraph 20(i)(£) of the Income Tax Act, Chapter 148 of the Revised Statutes of Canada, 1952, be deemed to have been used for the purpose for which the money previously borrowed was used or was deemed by this subsection to have been used, or to acquire the property in respect of which the amount was payable, as the case may be.

Both the plaintiff, who opposes the deduction of the interest in question, and the defendant, who claims to be entitled to that deduction, rely essentially on the decision of the Supreme Court of Canada in Bronfman Trust v. R., [1987] 1 S.C.R. 32 (S.C.C.), to justify their positions.

In that decision, Chief Justice Dickson pointed out, at page 49, the fundamental statutory requirement that “for interest payments to be deductible, borrowed money must be used for circumscribed income-earning purposes.” Then, referring to subparagraph 20(l)(c)(i) and subsection 20(3) of the Act, the provisions on which the defendant herein relies, Dickson C.J. wrote, at pages 49 and 50:

One finds in the Act not only the distinction within s. 20( l)(c)(ii) between eligible and ineligible uses of funds, but other provisions which also require the tracing of funds to particular uses in a manner inconsistent with the argument of the Trust. Section 20(3) (formerly s. 11(3/?)) stipulates, for example, that interest on money borrowed to repay an existing loan shall be deemed to have been used for the purpose for which the previous borrowings were used. This provision would, of course, be unnecessary if interest on borrowed money were deductible when the taxpayer had income-earning properties to preserve. On the contrary, however, for taxation years prior to the enactment of s. 11 (3b) in S.C. 1953-54, c. 57, s. 2(6), it had been held that such interest was not deductible since the borrowings were used for repay a loan and not to earn income: Interior Breweries Ltd. v. Minister of National Revenue, 55 D.T.C. 1090, at p. 1093 (Ex. Ct.) It is not surprising, therefore, that the cases interpreting s. 20(l)(c)(i) and its predecessor provisions have not favoured the view that a direct ineligible use of borrowed money out to be overlooked whenever an indirect eligible use of funds can be found. See Sternthal and also Garneau Marine Co. v. Minister of National Revenue, 82 D.T.C. 1171 (T.R.B.).

In a similar vein, it has been held repeatedly that an individual cannot deduct interest paid on the mortgage of a personal residence even though he or she claims that the borrowing avoided the need to sell income-producing investments....

A little farther on, the Chief Justice said that he agreed with the proposition stated in Trans-Prairie Pipelines Ltd. v. Minister of National Revenue (1970), 70 D.T.C. 6351 (Can. Ex. Ct.), that “it is the current use and not the original use of borrowed money that determines eligibility for a deduction,” specifying, however, at page 52:

...As stated previously, however, the fact that the taxpayer continues to pay interest does not inevitably lead to the conclusion that the borrowed money is still being used by the taxpayer, let alone being used for an income-earning purpose. For example, an asset purchased with borrowed money may have been disposed of, while the debt incurred in its purchase remains unpaid.

With the exception of Trans-Prairie, then, the reasoning of which is, in my opinion, inadequate to support the conclusion sought to be reached by the respondent Trust, the jurisprudence has generally been hostile to claims based on indirect, eligible uses when faced with direct by ineligible uses of borrowed money.

Then, acknowledging both the trend away from strict construction of taxation statutes and the “recent” trend in tax cases towards attempting to ascertain the true commercial and practical nature of the taxpayer’s transactions, the Chief Justice stated, at page 53:

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.

This does not mean, however, that a deduction such as the interest deduction in s. 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.

Ultimately, having regard to the specific facts of the case, the Chief Justice of the Supreme Court of Canada found against the taxpayer, but did acknowledge that there may be exceptional circumstances that would allow the deduction of interest on funds borrowed for an ineligible use. At page 54, he wrote:

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....

Analysis

I am of the view, having regard to the specific circumstances of this case, that the reasoning of the Supreme Court in Bronfman Trust, supra, clearly supports the position of the defendant taxpayer. The fact that the $65,625 hypothecary loan on the defendant’s principal residence enabled him to use that money to earn an income from his new business in Hull, Quebec, is not in dispute. Since the defendant had, in the same time period, sold the shares he owned in a similar business in Mascouche, Quebec, and also invested $90,194 of the $112,500 obtained for those shares in the new business he intended to operate in Hull, it was to be expected that the defendant would sell his residence in Rosemère, near Mascouche, and purchase a new one in Gatineau, Quebec, near Hull. Although the defendant paid off the $65,625 hypothecary loan when his residence in Rosemère was sold, he had to mortgage his new residence in Gatineau for an amount greater than $65,625: $151,700, paid entirely to the vendor of the residence in Gatineau. All these transactions were completed within a reasonable period of time: some ten months, during which the $65,625 advance to the business in Hull was still reflected in the business’s financial statements, as the defendant had not been repaid. These circumstances bear a striking resemblance to the ones that Mr. Justice Strayer considered in Shore v. Minister of National Revenue, [1992] I C.T.C. 34 (Fed. T.D.), in which the taxpayer, who operated a business similar to the defendant’s in this case, was allowed to deduct interest on a second mortgage loan that was used directly to pay for his new residence. In that case, Strayer J. wrote, at page 35:

Each case must turn on its own facts when a court is obliged to make such a characterization. tn the present case when one looks at the commercial reality of the situation one sees that there was a series of transactions the net result of which was to enable the taxpayer to borrow money in order to earn income from his business, using his private homes as collateral for the loan. It is important to note that at the beginning of these transactions the taxpayer and his wife were owners of their Thamesford home. (There is some indication in the material that there was a previous mortgage on the home but this was discharged prior to the registration of the mortgage in favour of Guaranty Trust.) It is not disputed that the taxpayer and his wife gave a mortgage on their home to Guaranty Trust in order to raise approximately $42,000 to use in their new business, Joline Automobiles Ltd., and that the net proceeds of that mortgage were loaned to the business. That amounted to a direct use of the money for purposes of the business. Later, when they needed to change homes, they were not able to repay the loan to Guaranty Trust out of the sale proceeds from their Thamesford home because the only practicable way of selling in that market was on the basis of cash to mortgage. Therefore the mortgage in favour of Guaranty Trust had to remain on the house in Thamesford. Similarly, in buying a house in Stratford, then, it became very important for the taxpayer and his wife to find a house with a similar mortgage and preferably with a similar rate of interest (interest rates having gone up substantially since the time they had granted a mortgage to Guaranty Trust.) As they had not sold their house in Thamesford for cash but only cash to mortgage, they were not in a position to pay the total price of another house in cash. They found a house in Stratford which was encumbered by a mortgage of a similar amount to the mortgage on their previous house, and they were thus able to pay cash to mortgage to acquire the house in Stratford. In my view the reality of that transaction, in taking on a house encumbered by the mortgage in favour of Victoria and Grey Trust similar t the one on their previous residence, was in essence the replacement of one borrowing money for the same purpose, thus bringing it within subsection 20(3) of the Income Tax Act so that such “borrowed” money could be deemed to be used for the same purpose as the original money borrowed from Guaranty Trust.

Therefore I find on the facts that the direct use of the money borrowed on the security of the family home was, and remained throughout, for the purposes of the automobile business and that the interest paid on the mortgage in the 1980, 1981, 1982 taxation years was properly deductible from the defendant’s income.

(Emphasis mine.)

Although in the instant case the first mortgage was repaid and the second mortgage was for a higher amount, I do not believe that these differences are sufficient to compel me to conclude otherwise than Strayer J. did in Shore on the essential points. In this case, I am of the opinion that there are exceptional circumstances in which, on a real appreciation of the taxpayer’s transactions, it is appropriate, because of the indirect effect on his Capacity to earn income from his business in Hull, to allow him to deduct the interest on the funds borrowed for an ineligible purpose, the purchase of his new residence in Gatineau. Considering the economic context of the transactions and the concurrence of the events, I am quite satisfied that the defendant’s real purpose in using the funds in question was to earn income. In my view, the exceptional circumstances referred to in Bronfman Trust, supra, at page 54, are present in this case.

Conclusion

For these reasons, the appeal cannot be allowed and the plaintiff’s action is dismissed with costs.