The Queen v. Merban Capital Corp. Ltd., 85 DTC 5014, [1985] 1 CTC 1 (FCTD), rev'd 89 DTC 5404 (FCA)

Joyal, J:—The trial of this action was held in Toronto on October 9, 10 and 11, 1984. The issue was the deductibility under the provisions of the Income Tax Act of a payment of $405,000 paid by MerBan Capital Corporation Limited to the Toronto Dominion Bank pursuant to an agreement involving these two parties dated October 16, 1972.

There were two other taxpayers who also had an interest in the issue, namely Michael F K Carter and George H Montague. It was common ground, however, that the interests of these two persons were identical with those of MerBan Capital Corporation Limited and the trial was conducted on the basis of common evidence.

MerBan Capital Corporation Limited, hereinafter referred to as MerBan, was incorporated under the Ontario Business Corporations Act on March 24, 1972. Its business was that of a merchant banker. Its objects were to carry on the business as investors, capitalists, financiers, brokers and financial agents and to undertake, carry on and execute financial tradings and other operations. It could also carry on the business of promoting, organizing, establishing, purchasing, acquiring, disposing or otherwise dealing in and with any corporations, companies, syndicates, enterprises or undertakings.

In the late summer of 1972, MerBan found that a public company called Kaps Transport Ltd, hereinafter referred to as Kaps, and operating out of western Canada and the Northwest Territories, might be the subject of a profitable investment. It will be recalled that in 1972, a tremendous amount of economic activity was predicted with respect to a proposal for a Mackenzie River pipeline, a megaproject estimated at some four to six billion dollars of which transportation alone would reasonably account for some 10 per cent. MerBan investigated the operation of the transport company, its history and track record. MerBan found that the timing was ripe to take over effective control of the company. It secured an option for a total of 450,000 shares of the company from the three Kapchinsky brothers. In its formal offer to these shareholders on September 22, 1972, MerBan also provided for a voting trust with respect to the remainder of the shares held by the optionees. The effect of this was to provide MerBan with voting rights on some 27 per cent of the outstanding Kaps shares and give MerBan effective control of the company. Through its investigations, MerBan was satisfied that the growth and profit potential of Kaps was most encouraging. It had been a family-run company some years and there was evidence that the infusion of new managers and new management methods would not only enhance the company’s profitability but would constitute other sources of income to MerBan as well.

The purchase of the 450,000 shares at the agreed price of $10 per share represented to MerBan a $4.5 million investment. It had equity to the amount of some $1 million to $1.25 million. The balance required financing. It negotiated for this with the Toronto-Dominion Bank (“the Bank’’). The Bank agreed to provide the financing.

The initial terms of the financing deal were reflected in an internal memorandum dated September 28, 1972 by the vice-president and manager of national accounts of the Bank. The proposal was for a term loan of three years in the amount of $2.5 million. An additional $1 million would be by way of purchase by the TD Capital Group of 6 per cent preference share. MerBan would put up the remaining balance of $1 million and that amount would represent its equity in the venture. Interest on the loan would of course be paid by MerBan and it was anticipated that the dividend on the preference share would be paid from a 15 cents per common share payout on the Kaps share held by MerBan.

By October 13, 1972, and following more negotiations between banker and borrower, the financing deal had taken on a more definitive form. The basic ingredients were still there but some fine-tuning had been done. MerBan’s equity participation would increase to $1.25 million.* [1] The Bank would lend $2.25 million secured by Kaps shares. The Bank, in anticipation of future growth and profit of the Company, would obtain an option to purchase 150,000 Kaps shares at the fixed price of $10 per share. Concurrently, MerBan would limit its liability to the value of the pledged Kaps shares and would limit its liability on the servicing costs of the loan to the sum of $500,000.

These new provisions in the basic agreement required more complex contractual arrangements. It was no longer a straight financing deal requiring a promissory note and a pledging of publicly-traded shares as security. MerBan was interested in limiting its liability to the value of the security. It was also interested in limiting its liability for interest on the loan. The Toronto-Dominion Bank was interested in gaining a foothold for future equity participation in the fortunes of Kaps. The Bank was also interested in getting Kaps’ banking business. All of these created a need for a highly complex structure with intervening corporate entities between the borrower MerBan at one end and the lending bank at the other. As a consequence, MKH Investments Ltd. (“MKH”) was incorporated all of whose shares were taken up by MerBan. Concurrently MerBan Kaps Holdings Ltd. (“Holdings”) was incorporated all of whose shares were owned by MKH and whose assets consisted of the 450,000 shares of Kaps.

With respect to the Bank’s participation, MKH issued a note for $2.25 million, hypothecated everything it had and received the bank loan. Concurrently, the Toronto-Dominion Bank paid $1 million to Holdings for the purchase of a 6 per cent income debenture. Holdings pledged its Kaps shares, granted the Bank an option to purchase 150,000 kaps shares, and naturally guaranteed the loan to MKH.

To translate this complex arrangement into contractual form, some 19 documents were delivered or exchanged between the several parties on the date set for closing, namely October 16, 1972.

Among the documents was an agreement dated October 16, 1972 between MerBan et al, as “Guarantors” and the Bank, obliging the “guarantors”:

(i) to pay or cause the Borrower (MKH) to pay all interest on the loan (as well after as before maturity and both before and after default with interest on overdue interest at the same rate) as and when the same shall become due and payable in accordance with the terms and conditions of the Loan Agreement; and

(ii) They will pay or cause to be paid to the Bank on the due date of a 6 per cent Income Debenture of MerBan-Kaps (“the Debenture”) of even date herewith, issued to the Bank, or on the date any part thereof is retired, an amount equal to the difference, if any, between the interest which has become due with respect to the Debenture or part thereof retired, as the case may be, and an amount equal to 6 per cent per annum thereof.

The agreement further provided that the aggregate liability would be limited to $500,000, and that during the currency of the agreement, the Guarantor(s) would:

(a) maintain direct or indirect control of MKH (the Borrower) and MerBan Kaps Holdings Ltd;

(b) cause the Borrower (MKH) not to carry on any business whatsoever

other than the ownership of shares of MerBan Kaps Holdings Ltd; and

(c) cause MerBan-Kaps not to carry on any business whatsoever other than the ownership of shares of Kaps Transport Ltd.

The agreement also provided that the obligation undertaken “‘shall be absolute and unconditional under any and all circumstances and shall not be to any extent or in any way discharged, impaired or otherwise affected except by performance in full.”

In due course, MerBan had to make good on its obligation to the Bank. The Mackenzie River pipeline did not materialize. The market price for Kaps Transport Ltd shares dropped. The Bank realized on its security. MerBan lost its $1,250,000 investment, and in 1974 paid a further $500,000 to the Bank under the terms of the above agreement.

At issue on this appeal is the treatment to be given under the provisions of the Income Tax Act to this $500,000 payment by MerBan to the Bank. The Minister of National Revenue treated it as non-deductible. An appeal to the Tax Review Board, as it then was, was allowed. The Crown now appeals to this Court.

Counsel for the Crown took the position that MerBan’s obligation to pay was by way of a guarantee and constituted a non-deductible outlay. Counsel for the Crown further contended that if the payment by MerBan to the Toronto- Dominion Bank was interest, it was not interest within the meaning of paragraph 20(1 )(a) of the Act nor did it satisfy the criteria imposed by subsection 20(1) or subsection 18(1) of the Act. Finally, counsel for the Crown urged me to find that the intervening companies were distinctly and separately created for business purposes, that each had a distinctive role to play, and the relationships which were imposed were matters of substance which could not be disregarded.

The substance of the taxpayer’s case on the other hand was that the amount paid out by MerBan was deductible for tax purposes, that the business purpose was clear, that the amount constituted a legitimate business expense, that such amount was interest and finally that the payment of it by the taxpayer constituted the discharge of a primary obligation to pay interest on borrowed money used in its business.

Before traversing any of these conflicting arguments, I should perhaps make certain findings on the evidence before me:

(1) I find that the whole venture was MerBan’s, that MerBan’s risk was exclusive and that MerBan alone stood to gain or lose from it;

(2) As corollary, I find that the intervening companies, namely MKH Investments Ltd and MerBan-Kaps Holdings Ltd, could neither profit nor lose from their participation. They may be called paper companies created for a single and individual purpose. Once that purpose had been achieved, they were functus. They were clones of MerBan and nothing more.

(3) I find that the creation of the intermediate companies was for technical purposes and to satisfy the requirements of both parties. As the memorandum of September 28, 1972 clearly indicates, the Bank had to find some justification for its participation along the lines of the proposal made to it by MerBan. The Bank through its equity group wanted an option on future participation in Kaps shares. It was also keenly interested in securing Kaps banking business and it relied on MerBan’s representation to it in this respect. The deal between the parties was a quid pro quo and without being able to distinguish between the quid and the quo, there was mutual agreement that providing every block in the financing deal was in place, the Bank was prepared to waive recourse against MerBan and limit liability for the loan interest to the sum of $500,000.

(4) I find that the Bank could not conceivably look to either of the intervening companies for any interest payments. Apart from the possibility of dividend payments to Holdings from Kaps, the two companies had no operations which might have generated income to service the debt nor did they have any assets which had not already been pledged directly or indirectly to the Bank and which the Bank could have seized in satisfaction.

(5) I find on the evidence that there was never any pretence on the part of the parties involved to look otherwise on the intervening companies as being essentially artificialities. The charging and collecting of outstanding interest by the Bank were from MerBan and MerBan alone. The process, which as I understood it, was a call by the Bank to MerBan to pay overdraft in the intermediary’s account which overdraft had been incurred by a bank entry representing an interest payout to the Bank, was itself artificial and constituted mere bookkeeping entries bereft of any substance.

(6) I find that the technical arrangements which were made were not for the exclusive benefit of MerBan. I find that:

(a) the importance of the non-recourse feature on the bank loan must be limited, in my view, by the realities of the situation then existing. The evidence is clear that the Bank enjoyed excellent coverage on its accommodation. Furthermore, under the terms of the hypothecation instrument the Bank could sell the Kaps shares “without notice whenever it should think proper to do so”. Further, the Bank did sell the shares when their value dropped to $7.50, a level where MerBan’s equity of $1,250,000 had been effectively consumed.

(b) the limitation on loan interest of $500,000 must also be viewed with the same sense of the realities. The loan agreement was for a relatively short-term of thirty months. At the rate charged by the Bank, at that time, the commitment by MerBan amounted to some 18 months of interest payment.

On the basis of these findings, I find it difficult to define MerBan’s obligation to the Bank as one of guarantor. It is fair to say that in essence a guaranty imposes a contingent liability on the guarantor, a liability which becomes very much real on the prime debtor’s default. In the instant case, it is apparent that the only source of income to the intervening companies was dividend payout by Kaps. Without dividend payouts, MerBan pays. MerBan, however, did not guarantee to the Bank that Kaps would pay dividends with which to service the debt. It did nothing of the sort. The parties simply decided that Kaps dividends would be a convenient source of income to MerBan with which to service the debt, and nothing more.

Generally speaking, it is in accordance with the scheme of the Income Tax Act that financing or other charges incurred by a taxpayer on moneys borrowed for business purposes or to secure gains or profits are deductible expenses. There can be no doubt that MerBan’s borrowings were for the purpose of making money. No taxpayer puts $1.25 million into a venture with the expectation of suffering a loss. Had the financing deal with the bank been less sophisticated, it is fair to say that MerBan’s $500,000 payment to the Bank would have been treated as a business expense.

The matter, however, cannot rest there. As was very ably argued by counsel for the Crown, a court should have regards to two salient features in jurisprudence. One of them, as was expressed in the Me Laws case,* [2] is that payments made pursuant to a guarantee are not deductible under the Income Tax Act. Counsel for the Crown urged me to find that not only in appearance but in fact, MerBan was a guarantor for the payments of interest. The agreement of October 16, 1972 between MerBan and the Bank described MerBan as guarantor. The primary obligation to pay interest rested with MerBan Kaps Holdings Ltd as to $1 million of principal and with MKH Investments Ltd as to $2.25 million of principal. Counsel argued that I should adhere strictly to the form of the several transactions and hold that the payment eventually made by MerBan was as guarantor and not as primary debtor.

The Supreme Court of Canada in the Me Laws case, confirming an earlier decision in the Exchequer Court, dealt with the issue of a taxpayer paying money on a guarantee and attempting to charge it off as an expense. The taxpayer, in an effort to keep his company alive had provided a bank with his personal guarantee on company loans. It was held, per Hall, J that “the interest paid by the appellant and which he claims should be allowed as a deduction is not in my view an amount paid pursuant to a legal obligation to pay interest on borrowed money used for the purpose of gaining income. The interest paid by the appellant was not on an advance made to him but was paid on the principal sum remaining unpaid under his guarantee.”

By reason of the findings I have made earlier, the principle applied to the McLaws case does not appear to be applicable to the present case.

The other salient feature advanced by counsel was that I should be wary of tearing away corporate veils so to speak and that I should logically follow the principle recently laid down by Madam Justice Wilson [sic] of the Supreme Court of Canada in the Stubart case.* [3] In part of her lengthy treatment of the legal effects given to intercorporate relationships, Madam Justice Wilson [sic] said:

I would therefore reject the proposition that a transaction may be disregarded for tax purposes solely on the basis that it was entered into by the taxpayer without an independent or bona fide business purpose.

As I understood counsel’s reference to this case, it was to suggest that what is sauce for the goose is sauce for the gander. If the law cannot strip the corporate veil when the purpose of multiplied transactions is a more favorable tax treatment, it should be consistent in its reverence for the form when the shoe is on the other foot. This would mean in essence that MerBan created a structure of its own design, interposed two companies between it and its banker and got the benefit of it through the provision of non-recourse and limited liability.

I should state at this point that the evidence is far from clear that the intricate mechanisms were at the instance or for the benefit of MerBan and that MerBan should suffer the consequence of them. The benefits gained by MerBan, as analysed before, were of minor value when the Bank, as was admitted, already enjoyed good coverage and could under its hypothecation of the Kaps shares sell them “without notice whenever it should think proper to do so.” Furthermore, as already indicated, the limitation on interest liability is not that considerable when it secures interest on the whole amount for some 18 months of a thirty- month loan.

I should also elaborate on the finding that MerBan undertook a prime obligation vis-a-vis the Bank. When one says that the Bank is said to look to MerBan for payment, it is because it can’t look to anyone else. It will be recalled that one intervening company had no income at all. The other one could only expect $45 thousand to $65 thousand in Kaps dividends, barely enough to pay interest on the income debenture, let alone pay interest on the remaining $2.25 million loan.

This situation makes it quite clear to me that notwithstanding the legalistic base of the two intervening companies and notwithstanding that, for purposes of utter conformity, MerBan is described in one instrument as a guarantor, I have concluded that its obligation to the Bank was for the purpose of this case as prime obligor.

Case law provides many instances where the subject matter of interest has been treated. A decision of this Court in the Roynat case* [4] discusses the implications of guarantees on income bonds as “income bonds”. Roynat, in its investments and loans programmes, had advanced moneys on certain bonds issued by debtors who were required to pay interest on the bonds only and when they made a profit. Roynat, however, wanted guarantees for the payment of the income on the bonds whether or not the debtors made a profit out of which interest on income would be paid. The guarantors eventually had to make good on their guarantees and Roynat received the equivalent of interest from them. The Court decided that by reason of these guarantees, income received by the taxpayer constituted interest income and, not as would otherwise have been the case, dividend income.

Addy, J, in his considered judgment, elaborates on the subject of “interest” and “guarantee” and the nature of a payment made by a guarantor to a creditor when the principal debtor is in default. He quotes a number of cases which were referred to me by counsel in their arguments. If his decision is to the effect that an “income” bond may be in reality an “interest-bearing” bond, so too the guarantee of October 16, 1972 may be by its nature or substance a straight commitment to pay interest.

The Canada Safeway casef [5] and the Massey-Ferguson^ [6] case were also quoted by counsel. The judgment of the Supreme Court in the Canada Safeway case confirms the principle that charges on borrowed money may only be deductible when used by the taxpayer in its own business to earn income. It may not be deducted to earn non-taxable income.

The Federal Court of Appeal in the Massey-Ferguson case was faced with another provision of the Income Tax Act, namely subsection 19(3) and paragraph 139( l)(aq) of the statute as it then was. In that case, Massey-Ferguson had used an intermediate subsidiary, Verity, to provide a non-interest bearing loan to a US subsidiary. The parent company thus avoided a deemed interest receipt on the loan pursuant to section 19 of the statute.

There was evidence, however, of a historical relationship between Massey- Ferguson and Verity. The latter company had been from time to time used as a vehicle for loans to the taxpayer’s subsidiaries.

The Federal Court of Appeal, per Urie, J, did make a finding in that respect when he said at 14 [5019]:

Thus, the legitimacy for the existence of Verity cannot be an issue. Its holding of all of the outstanding shares of Perkins was part of the reason for its existence and the loan of money to Perkins was a legitimate part of its business of lending money to other Massey-Ferguson subsidiaries. However, the learned Trial Judge, despite these facts, concluded that the only purpose for interposing Verity in the transaction was “an attempt to keep the transaction outside of section 19(1).’’ He was of the opinion, further, that the intervention of Verity was a sham.

I am unable, with respect, to agree with this view of the transaction. As I have said, the evidence discloses that one of the reasons that Verity was in business was to lend money to Massey-Ferguson subsidiaries and there is some evidence derived from its financial statements to show that it did so, not only in the case at bar, but also in other cases. The money for such purpose was acquired, in other cases, as well as in this, by borrowing from Verity’s parent, the Appellant. Neither the existence of the corporate entity, nor the business in which it was engaged was in any way a sham.

That being so, was something done in the case at bar which made the loan transaction a sham as the Trial Judge has found? In general, it may be stated that if there are two ways in which a transaction may be carried out, one of which involves a liability for the payment of tax, and the other of which results in a reduction or elimination of such a liability, then, if the transaction is otherwise a bona fide commercial one, there is no reason for not adopting the tax saving method. That principle is stated succinctly in Inland Revenue Commission v. Brebner [1967] 1 All E.R. 779 by Lord Upjohn at page 784, as follows:

“My Lords, I would conclude my judgment by saying only that, when the question of carrying out a genuine commercial transaction, as this was, is considered, the fact that there are two ways of carrying it out — one by paying the maximum amount of tax, the other by paying no, or much less, tax — it would be quite wrong as a necessary consequence to draw the inference that in adopting the latter course one of the main objects is for the purposes of the section, avoidance of tax. No commercial man in his sense is going to carry out commercial transactions except on the footing of paying the smallest amount of tax involved.”

For the reasons I have stated, such is not the situation before me. Before the Federal Court of Appeal the issues were substantially different. Their Lordships made certain inferences from facts which, in the opinion of the Court, had no element of “sham” in it, and found that there was a quality of legitimacy in the relationship which the Court did not wish to disturb.

In the case at bar, the elaborate structure was established for one deal and one deal only. The intervening companies were created for one purpose and one purpose only. When that purpose was achieved and the bank loan repaid, they were wound up. The complexities in the closing documents may speak of the proclivity of corporate counsel in assuring that every technical crack is filled and every legal hole is plugged. They do not, in my view, change the essential reality of the transaction. Nor do they change the one on one relationship between MerBan and the Bank.

There were any number of other cases cited by both counsel in support of their respective positions. An extensive reading of the judgments led me to conclude that they are in the category of hard cases where the sanctity of intercorporate relationships in tax matters is sometimes respected, sometimes not, and where instruments are interpreted in a literal sense and sometimes not. These cases, if seemingly in conflict, seem to be decided on the basis of their particular facts which require a particular treatment. The principles enunciated therein are very necessary anchors to ensure stability in statute interpretation but the anchor chain should not be played out so as to impede the proper disposition of factual issues.

Having made the foregoing findings, I need not engage in a detailed analysis as to whether the amount paid by MerBan to the Bank is deductible under section 18 or section 20 of the Income Tax Act. Whether that payment is categorized as interest in the true sense, or a cost of doing business, or a flat-rate charge, or rent for the lease of the Bank’s money, the amount constitutes an allowable deduction.

The appeal is dismissed with costs. The decision of the Tax Review Board, now the Tax Court of Canada, is confirmed. I also confirm the order issued by the Honourable Judge L Cardin as regards MerBan, George H Montague and Michael F K Carter.

Finally, I do wish to extend my thanks to counsel on both sides for their generous assistance and kindly disposition throughout the trial.