Lakeview Gardens Corp. v. MNR, 73 DTC 5437, [1973] CTC 586 (FCTD)

Walsh, J:—This is an appeal from the decision of the Tax Appeal Board dated March 30, 1971, dismissing the taxpayer’s appeal with respect to its assessment for the 1966 taxation year.

The appellant corporation was incorporated on July 8, 1954 and was engaged in the purchase and sale of real estate and its fiscal year ends on June 30. On July 26, 1954 it purchased a large tract of land for a price of $562,662.78, paying on account therefor the sum of $280,000, leaving an unpaid balance of $282,662.78, for which a note was given to the vendors. The initial down payment of $280,000 was financed to the extent of $40,000 by the issuance of shares and the balance of $240,000 was borrowed from a Swiss bank called Bank Landau & Kimche. All the shareholders are non-residents. Commencing during the year 1955 and continuing each year thereafter certain sales of land were made and some cash payments and interest-bearing balances of sale were received therefor which land sales produced taxable income.

During the course of its 1962 fiscal year appellant acquired shares in a United States corporation entitled Martin County Investment Corporation for a price of approximately $175,000, of which $50,000 was payable by a promissory note not bearing interest. This was a wholly owned subsidiary so that appellant during the years 1962 to 1965 at all times owned more than 25% of the stock of this corporation with the result that dividends therefrom, had there been any, would have been tax exempt to appellant. During these same four years appellant sustained certain losses so it was not until 1966, when appellant sold the balance of the land purchased in 1954 for $725,000 that the issue of the deductibility of expense creating losses in the four preceding years arose. At the end of its 1961 fiscal year the land in question was valued in the books of the company at $102,343. In the intervening years between its acquisition and sale expenses in con- nection with the holding of the land, such as carrying charges and taxes, had not been capitalized but had been charged off as expenses in the year in which they were incurred.

At the end of its 1961 fiscal year appellant’s assets were as follows:

Cash in Bank —

Bank of Montreal
Canadian Funds	$ 411.96
Chemical Bank New York
Trust Co. U.S.A. Funds	7,132.29
Royal Trust Co.
Guaranteed Investment Receipts	65,000.00
Balances Receivable	206,502.48
Land at cost	102,343.86
Prepaid Interest	12,606.57
Total Assets	$393,997.16

Its indebtedness at the end of its 1961 fiscal year and at the time of the purchase by it of the shares in Martin County Investment Corporation was $301,337.50. Its surplus at the same date was $49,179.60 in addition to the $10,000 of capital stock. The remaining difference between assets and liabilities was made up by a figure of $33,480.60 being a reserve for uncollected accounts. The interest bearing note referred to in the amount of $240,000 arising from the original purchase of the land was reduced to $200,000 in appellant’s 1965 fiscal year and to $125,000 in its 1966 fiscal year. During the 1965 taxation year appellant liquidated its investment in shares of Martin County Investment Corporation by winding it up, the promissory note of $50,000 being cancelled. Appellant received a further $38,000 from the liquidation.

In the Agreed Statement of Facts the company’s cash flow for the fiscal years 1955 to 1965 in round figures was as follows:

It is appellant’s contention that no money was borrowed and no interest was paid in connection with the acquisition of the Martin County Investment Corporation shares in 1962 as it had $131,000 available to make the $124,000 payment made that year. Furthermore, that at the end of its 1965 fiscal year as the result of the receipt of $38,000 from the sale of the shares in that company $1,000 would have remained in its cumulative cash balance even had the $124,000 cash paid for these shares been paid out of this accumulated cash balance during the year 1962.

Respondent contends that in reporting business losses for its fiscal year 1961 to 1965 appellant deducted in the years 1962 to 1965 the following amounts on account of interest on borrowed money:

when certain portions of the interest were expended or laid out on account of borrowed funds used to acquire shares in Martin County Investment Corporation, the income from which was exempt, which portions of interest were therefore disallowed by respondent when reassessing the appellant for its 1966 fiscal year as follows:

with the result that its business losses carried over to its 1966 fiscal year should have been as follows:

In addition to this respondent contends that of the amount of $15,733 deducted by appellant as interest on borrowed funds in computing its income for its 1966 taxation year, the amount of $4,765.53 was on account of interest paid on funds borrowed and used to acquire the shares in Martin County Investment Corporation and hence not deductible under paragraph 11 (1)(c) of the Income Tax Act.

In support of this contention respondent argues that appellant had available to it the borrowed sum of $300,000 (which is the figure used by respondent throughout its pleadings) prior to its 1962 fiscal year all of which was used for the purpose of earning income from a business, the income of which was not exempt so that the interest on this could be properly deductible in computing the income of appellant for the relevant taxation years, but that after the end of its 1961 fiscal year, portions of the sum borrowed were used for the purpose of earning income from property, namely, shares in Martin County Investment Corporation, the income of which would have been exempt in computing the income of appellant in the relevant taxation years. Hence the portion of the interest for this purpose is non-deductible. To summarize therefore respondent contends that the following amounts of interest should not have been deducted by appellant pursuant to paragraph 12(1 )(c) of the Income Tax Act:

Two questions have to be decided, the first being whether in the absence of any new borrowings by appellant the acquisition in 1962 by it of the Martin County Investment Corporation shares can be considered as having been made with borrowed capital as a result of the fact that the original indebtedness of appellant in 1964 through the purchase of land, the income of which was not exempt, still remained unpaid in 1962, and if an affirmative conclusion is reached on this question, then subsidiarily whether the proper apportionment was made by the Minister of the interest between investment of appellant in Martin County Investment Corporation shares, the income of which was exempt, and its investment in other assets, which computations were made allegedly on an actual cost basis.

lt will be convenient here to quote the sections of the Act in question.

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:

(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 an interest in 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 . . .

12. (1) In computing income, no deduction shall be made in respect of

(c) an outlay or expense to the extent that it may reasonably be regarded as having been made or incurred for the purpose of gaining or producing exempt income or in connection with property the income from which would be exempt,

Both these sections are applicable and must be given equal weight. Since the preamble of subsection 11(1) excludes the application of paragraphs (a), (b) and (h) of subsection (1) of section 12, it follows that the application of paragraph (c) of subsection (1) of section 12 is not excluded. (See MNR v United Auto Parts Limited, [1961] CTC 439 at 444; 61 DTC 1259 at 1262, and the recent judgment of Mr Justice Heald in The Canadian Rock Salt Company Limited v MNR, [1973] CTC 143 at 147; 73 DTC 5122 at 5125.) What distinguishes the present case from most of the preceding jurisprudence, however, is the fact that there was no new borrowing for the purpose of acquiring the shares in question. (See cases referred to by respondent in all of which no new borrowing was involved, namely, Canada Safeway Limited v MNR, [1957] CTC 335; 57 DTC 1239; Auld v MNR, 28 Tax ABC 236; 62 DTC 27; MNR v People's Thrift and Investment Company, [1959] Ex CR 262; [1959] CTC 185; 59 DTC 1129; Trans-Prairie Pipelines Limited v MNR, [1970] CTC 537; 70 DTC 6351; Interior Breweries Limited v MNR, [1955] Ex CR 165; [1955] CTC 151; 55 DTC 1090; The Canadian Rock Salt Company Limited v MNR (supra); MNR v United Auto Parts (supra).)

Appellant contends that it is absurd to say that even if no new borrowing is involved in acquiring tax exempt shares in a subsidiary the Minister can analyse retrospectively all the past borrowings of the company made for the purpose of acquiring its inventory, in this case land, to determine how much is still outstanding on those loans and hence to conclude that the previous borrowing must have been used in whole or in part to acquire the tax exempt shares, for the company might well have made $1,000,000 from the sale of its land before acquiring the tax exempt shares but still have had outstanding borrowings, having chosen to re-invest these profits in further land acquisitions rather than pay off its outstanding indebtedness. There is nothing to require a taxpayer to use available funds for payment of outstanding indebtedness, and appellant contends that the Minister cannot penalize a taxpayer if he does not choose to do so as this would be an unwarranted interference with the conduct of the taxpayer’s business. However, as has been frequently pointed out, it is not what the taxpayer might have done to minimize taxation that determines the issue but the taxpayer must abide by the position which it has taken. This principle was set out in the frequently cited judgment of Lord Simon in Commissioners of Inland Revenue v Wesleyan and General Assurance Society, 30 TC 11, when he said at page 25:

It may be well to repeat two propositions which are well established in the application of the law relating to Income Tax. . . .

Secondly, a transaction which, on its true construction, is of a kind that would escape tax, is not taxable on the ground that the same result could be brought about by a transaction in another form which would attract tax. As the Master of the Rolls said in the present case: “In dealing with Income Tax questions it frequently happens that there are two methods at least of achieving a particular financial result. If one of those methods is adopted tax will be payable. If the other method is adopted, tax will not be payable. . .. The net result from the financial point of view is precisely the same in each case, but one method of achieving it attracts tax and the other method does not. . . .

Counsel for respondent concedes that had appellant used the $131,000 cash flow available to it at the end of its 1961 fiscal year to buy land, to reduce indebtedness, or otherwise there would have been no problem and hence that the onus is on appellant to establish that it was this money which was used to buy the tax exempt shares, and that it has failed to discharge this burden since some $300,000 of its originai indebtedness remained outstanding at the time even though it also had assets in addition to land in the form of bank deposits, guaranteed investment receipts and balances receivable. Similarly, in answer to appellant’s argument that $202,208.32 had been expended on its in- ventory, the land, including taxes and interest to the end of its 1961 fiscal year, although the property was only carried on the books at $102,343.86 and that these sums should be added to determine the real value of the land, it can be said that appellant chose not to capitalize expenses on the land. If it had done so appellant would not have shown losses for the years 1959 to 1965 and would have paid taxes in those years, although paying iess tax in 1966 when the property was disposed of at a substantial profit. Having adopted the alternative method of accounting appellant must abide by this, and if interest expense is to be apportioned between the non-tax-exempt and tax- exempt property the figure of $102,343.86 is the value properly attributable to the non-iax exempt property.

Counsel for appellant also says that a distinction should be made between a pure holding company and a mixed holding company such as the present, in that in previous cases the taxpayer has attempted to allocaie the interest but has never succeeded, although that is just what the respondent is now attempting to do. The Minister attempted this in the Trans-Prairie Pipelines case (supra), decided in favour of the taxpayer, the allocation not being allowed, but it appears that this was a case of instantaneous substitution, money having been borrowed by way of debentures, part of which was used to redeem preferred shares of the company. The Court agreed with the taxpayer’s contention that after the moneys subscribed by the preferred shareholders had been withdrawn the company was still left with the total amount subscribed by common shareholders and the total amount of the borrowed money, even though part of same had been used to redeem the preferred shares.

In the Canada Safeway case (supra) in the Supreme Court the company was also a mixed holding company. It again refused to allocate interest paid on debentures part of which was used to purchase capital stock of another company which company, as well as the appellant, were both wholly owned subsidiaries of an American company.

The case of MNR v United Auto Parts (supra) is another case of instantaneous substitution similar to the Trans-Prairie Pipelines case although a different conclusion was reached, as it was held that on the facts of this case in which money was borrowed by debentures to repay money borrowed from the bank which had been used to purchase shares in some subsidiaries, the income from which would have been exempt income to the taxpayer, was not money borrowed to earn income from a business or property under paragraph 11(1 )(c) but was used to acquire property the income of which was exempt under paragraph 12(1)(c) which disallowed the deduction. This case distinguished the case of MNR v People's Thrift and Investment Company (supra) which had found in favour of the taxpayer and had refused an apportionment of interest. In that case the company had acquired shares in a wholly owned subsidiary to be paid for by instalments out of money borrowed for the purpose. Four years later and again six years later money was borrowed to repay these previously borrowed sums and part of the interest on it was disallowed by the Minister as being an expense for the acquisition of the shares of the subsidiary. It was held that the sums so borrowed were not used to pay for the stock of the subsidiary but to a certain extent to repay previously borrowed sums which had been used to buy the subsidiary’s stock and that neither paragraph 11(1)(c) nor 12(1)(c) especially applied to a taxpayer who borrowed money to repay borrowed money used to acquire property the income of which would be exempt. The facts of that case were substantially different from the present one where there was no new borrowing, but I refer to it merely because of the distinction made by Mr Justice Kearney in MNR v United Auto Parts (supra) in which he states at page 445 [1263]:

In the present case, the lapse of time between the original borrowings from the Bank, which were used to pay for the shares, and the subsequent borrowings from the same party through debentures can be counted in terms of months if not weeks. The corresponding lapse of time in the Thrift case has to be reckoned in years. Moreover, in the Thrift case, the subsequent borrowings were made from other parties than the original lender. Unlike in the present case, where a retroactive effect was given to the later borrowing which, to all intents and purposes, eliminated the first to the same extent as if it had never been made, in the Thrift case it was proven that it was impossible to trace back the later borrowings, which were effected -in 1949- 1951, or connect them with the purchase of shares made in 1945. In the People’s Thrift case, the taxpayer’s stock-in-trade, so to speak, was that of borrowing and lending money.

Appellant argues in the present case that there was a substantial lapse of time between the original borrowing in 1954 to purchase lands and the purchase of the shares of Martin County Investment Corporation in 1962, and that by 1962 appellant had at its disposal, in addition to the outstanding balance of its original borrowing, land with substantially more than its book value at the time and additional liquid assets with which to buy the stock. However, I do not find that this is sufficient to conclude that no part of the money originally borrowed was used to purchase the shares in the subsidiary company, the income of which would be tax exempt, nor does the jurisprudence lead to a conclusion that under no circumstances in a case of a mixed holding company can the interest on borrowed money be apportioned between that paid on the portion of the loan used in a company’s business to produce taxable income and that used to acquire shares in a subsidiary company the income from which investment would be tax exempt.

In the Canada Safeway case (supra) Mr Justice Rand states at pages 344-5 [1244]:

lt is important to remember that in the absence of an express statutory allowance, interest payable on capital indebtedness is not deductible as an income expense. If a company has not the money capital to commence business, why should it be allowed to deduct the interest on borrowed money? The company setting up with its own contributed capital would, on such a principle, be entitled to interest on its capital before taxable income was reached, but the income statutes give no countenance to such a deduction. To extend the statutory deduction in the converse case would add to the anomaly and open the way for borrowed capital to become Involved in a complication of remote effects that cannot be considered as having been contemplated by Parliament. What is aimed at by the section is an employment of the borrowed funds immediately within the company’s business and not one that effects its purpose in such an indirect and remote manner.

Appellant argues that the borrowed funds were immediately employed in the company’s real estate business in 1954.

This does not settle the issue in the present case, however, for money can be originally used in the taxpayer’s business to acquire inventory and then revolve and come back in the ordinary course of trade and be used again, and if the borrowed money is then used to acquire property the income from which would be tax exempt, the portion of interest paid on the borrowed funds used for the acquisition of this tax exempt property would not be allowable. The comments of Chief Justice Jackett in Trans-Prairie Pipelines, Ltd v MNR (supra) at 540-41 [6353-4] are pertinent in this connection:

The difficulty arises from the fact that, in ordinary parlance, when one talks of the use of money in a business to earn income, one is referring to the mass of capital dedicated to that business, through all the different forms through which it passes while it remains in the business, and, when one talks of using money to acquire property or to pay a debt, one is referring to using money to make a particular payment as a result of which the payer no longer has that money.*

When a business person has borrowed money to use in a business, he is, according to the ordinary use of language, using that borrowed money in his business to earn income therefrom even though part of it has been converted into “bricks and mortar” and part of it was paid out during the first year for inventory and by way of salaries. Indeed, except in very unusual circumstances, he is using that borrowed money in his business to earn income until the loan matures and is paid off. By contrast, the actual money borrowed will, according to the ordinary use of language, have been “used” to acquire plant and machinery and to pay running expenses and will, in fact, have completely ceased to belong to the business man once it has been so used.

It would not, of course, be completely absurd to attribute the latter sense to the words “money used” where they first appear in Section 11 (1)(c)(i). Whether or not interest is deductible on borrowed money during each year of the life of a loan would then depend upon whether the first expenditure of the money after being borrowed was an expenditure for the purpose of the business. That test would, in most cases, produce the right result. However, in my view, such an interpretation is not only not in accordance with the ordinary sense of the words as used in the context, but it results in a rule that is not sound in principle. For example, a parent company such as the appellant company in D.W.S. Corporation v. M.N.R., [1968] 2 Ex.C.R. 44; [1968] C.T.C. 65 (affirmed Can. S.C.), having raised some borrowed capital, could use it on one occasion to acquire inventory for its business and could then, when it comes back in the ordinary course of trade, put it at the disposal of a subsidiary for the balance of the term of the loan and charge the interest as an expense of the parent’s business. If, on the other hand, the words “money used for the purpose of earning income in a business” are given their ordinary sense in this context of interest on borrowed capital, the obviously sensible result achieved in the D.W.S. case would flow whether borrowed capital was turned over to a related company without ever being. used in the borrower’s business or was turned over to a related company after being so used for a limited time. Surely, what must have been intended by Section 11(1)(c) was that the interest should be deductible for the years in which the borrowed capital was employed in the business rather than that it should be deductible for the life of a loan as long as its first use was in the business.

*In my view, both uses of the word “used” are to be found in Section

11(1)(c)(i) and the context dictates different meanings even though the same word is used twice in one paragraph. Where borrowed capital has been used by a Canadian company to buy shares the dividends from which are tax exempt, interest thereon does not qualify under Section 11 (1)(c)(i) because (a) the borrowed capital was not “used” to earn income from the borrower’s own business, and (b) it was “used” to acquire property the income from which was exempt. Compare Interior Breweries Limited v. M.N.R., [1955] Ex.C.R. 165; [1955] C.T.C. 151, Canada Safeway Ltd. v. M.N.R., [1957] S.C.R. 717; [1957] C.T.C. 335; and M.N.R. v. United Auto Parts Limited, [1962] Ex. C.R. 96; [1961] C.T.C. 439.

I have reached the conclusion, therefore, that to the extent that borrowed money was used to acquire the shares of Martin County Investment Corporation the interest payable on such borrowing would be nondeductible. In reaching this conclusion I may say that I am not relying only on paragraph 11(1)(c) but also on paragraph 12(1)(c). If we had been dealing with a capital sum paid to acquire these shares this would clearly have been an oui’ay or expense in connection with property (ie the shares) the income of which would be exempt. Instead we are dealing only with the interest paid on the amount of borrowed money deemed to have been used to acquire such shares. The same principle applies and this is confirmed by paragraph 11(1)(c) which excludes from interest paid which would otherwise be deductible that interest paid on borrowed money used to acquire property the income from which would be exempt (in subparagraph (i)) and interest on an amount payable for property the income from which would be exempt (in subparagraph (ii)).

The second question now arises therefore as to whether the correct apportionment was made by the Minister. Appellant contends that it is unreasonable to take the book value of the land on the one hand which had consistently increased in real value since its acquisition in 1954 and on the other hand the book value of its investment in the shares of Martin County Investment Corporation which went down in value between the date of their acquisition in 1962 and their disposal in 1965, as the figures on the basis of which the interest on its outstanding loans should be pro-rated. I have already dealt with land valuation pointing out that the company must abide by the position it took in its accounting statement and accept the valuation of $102,343.86 for this. The question of the figure to be taken for its investment in the Martin County Investment Corporation shares is more complicated. It paid $124,000 in round figures for the shares in 1962 and undertook to pay an additional $50,000 by means of a promissory note which did not, however, bear interest, so no interest expense was incurred by appellant in connection with this note. The evidence as to what was done with this note when Martin County Investment Corporation was liquidated in 1965 is not too clear. Paragraph 8 of the Agreed Statement of Facts states that “the Appellant bought these shares for approximately $175,000 of which $50,000 was paid by promissory note”. Paragraph 9 states, however, that “during the taxation year 1965 the Appellant liquidated its investment in the shares of Martin County Investment Corporation through the winding-up of the company. The promissory note of $50,000 was cancelled and the Appellant received a further $38,000 from the liquidation.” Possibly the word “paid” in paragraph 8 should more accurately have been stated as “payable”. The use of the word “cancelled” in paragraph 9 would not seem to indicate that the note was paid especially since reference was made to a “further” $38,000 from the liquidation. The situation is not clarified by an examination of the figures used by respondent in calculating the proportion of the interest to be disallowed as appears from the schedule produced before the Tax Appeal Board. These figures taken from the appellant’s financial statement use the figure $123,886.13 as investment for each of the years 1962, 1963 and 1964, increase this to $173,886.13 in 1965, and reduce it to $70,912 in 1966. Appellant’s financial statement shows as a liability “notes payable USA funds” $50,000 for each of the years 1962 and 1963, designates the same amount as “Loans, sundry, USA funds” in 1964 and increases this to $88,000 in 1965. In 1966 a figure of $70,912 is shown as an asset as “investment at cost less recoveries”, from which a reserve of $7,000 for loss on realization is then deducted, and the entry for the loan on the liability side disappears.

On the whole it appears that appellant never expended more than $124,000 in connection with this investment and of this sum it received back $38,000 in 1965 from the liquidation of the company.

I have also reached the conclusion that it is not reasonable to consider the entire payment made in 1962 as having been made out of borrowed money. While I do not accept appellant’s contention that since it had sufficient cash flow to make the payment without using any borrowed funds the purchase should be considered as having been entirely made without any use of its previous borrowing, I do consider that it is reasonable that it should be considered as having been made at least in part out of the company’s surplus available at the time of the purchase. Without impairing its capital and using any part of the $10,000 invested in capital stock, appellant had $49,179.60 available out of surplus and I believe that this should be deducted from the $124,000 in round figures paid for the shares with only the balance of $74,820 in round figures being considered as having been paid out of borrowed funds. When the $38,000 was received by the company in 1965 on liquidation of the Martin County Investment Corporation it had the effect of reducing appellant’s net investment in the shares of the company at that time by this amount leaving a balance of $86,000 invested of which again $49,179.60 would be considered as having been invested out of the company’s surplus with only the balance of $36,820 in round figures having been invested by use of borrowed funds. Since these conclusions involve an entire recalculation by respondent of the portion of interest payable by appellant on its borrowed funds during the years in question attributable to the tax exempt investment, I will refer the matter back to the Minister for recalculation in accordance with these findings.

I therefore allow the appeal in part referring the matter back to the Minister for reassessment and, should the parties fail to agree with respect to the reduction to be effected, I will allow counsel to speak again to the matter. Since appellant has only been partially successful in its appeal, no order will be made with respect to costs.