Sternthal v. The Queen, 74 DTC 6646, [1974] CTC 851 (FCTD)

Kerr, J:—This is an appeal by the plaintiff from a judgment of the Tax Review Board respecting an assessment of income tax for the plaintiff’s taxation years 1967 to 1970 inclusive. The Minister disallowed claimed deductions from income of interest on $246,800 of borrowed money on the ground that the interest was not interest on “borrowed money used for the purpose of earning income” within the meaning of paragraph 11(1)(c) of the Income Tax Act. The Tax Review Board held that the borrowed money did not serve to earn income, and dismissed the plaintiff’s appeal.

On the appeal to this Court common evidence was presented consisting of an “Agreed Statement of Facts and Documents”, which reads as follows:

The parties, herein represented by their respective solicitors, hereby admit the facts and documents hereinafter set forth:

1. During the taxation years 1966 to 1970, the Plaintiff owned the income bearing assets and non-income bearing assets reflected in the financial statements forming part of the common evidence, and was indebted to the bank or other creditors, as therein set forth;

2. On December 22, 1966, Plaintiff borrowed an amount of $246,800 from:

J Sternthal Textiles Inc	$ 88,300.
Car Park Inc	38,500.
Planned Homes Inc	120,000.
TOTAL	$246,800.

3. At the same date, Plaintiff was reimbursed an amount of $35,200.00 from the following corporations:

Elmcrest Realty Ltd	$ 26,200.
Joel Investment Corp	9,000.
TOTAL	$ 35,200.

4. These two amounts, namely $282,000.00, were deposited the same day in Plaintiff’s bank account, while the previous balance in the said bank account was $1,518.52;

5. On the same day, Plaintiff made interest-free loans to his four (4) children, namely:

Mrs Judi Gilber	$ 70,200.00
Bernard Sternthal	70,200.00
Melvyn Sternthal	70,200.00
Norman Sternthal	70,200.00
TOTAL	$280,800.00

6. The borrowing of $246,800.00 formed part and is included in the loans payable (sundry accounts) of the said financial statements; the $246,800.00 is also, as therein after referred to “loans receivable”, within the non-income bearing assets group;

7. On the borrowings made on December 22, 1966, in the amount of $246,800.00 Plaintiff claimed the deductibility of the following amounts of interest, which were disallowed by the Minister of National Revenue:

1967	$ 8,947.66
1968	11,676.00
1969	19,046.00
1970	19,300.00

8. The question for the opinion of the Court is whether or not the amount of $246,800.00 constituted borrowed money used by Plaintiff for the purpose of earning income from a business or property, within the meaning of Section 11 (1)(c) of the Income Tax Act, RSC 1952.

The documents include extracts from balance sheets of the plaintiff, assets, liabilities, earnings, etc.

Subparagraph 11 (1 )(c)(i) of the Act reads as follows:

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

(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),

Counsel for the plaintiff, in his argument, relied mainly on the decision of Jackett, P (as he then was) in Trans-Prairie Pipelines, Ltd v MNR, [1970] CTC 537; 70 DTC 6351.* [1] The facts in that case are summarized in the [DTC] headnote as follows:

The appellant company was incorporated in 1954 to construct and operate a pipeline, its original issued capital being a number of common shares and 140,000 redeemable preferred shares, the latter having a total par value of $700,000. In 1956 the company issued $700,000 first mortgage bonds and used $400,000 of the amount so borrowed (with $300,000 obtained by issuing additional common shares) to redeem the preferred shares. In 1956 (and subsequent years) the company deducted the interest paid on its bonds; in 1956 it also deducted (under section 11(1)(cb)) legal expenses incurred in connection with the bond issue and the preferred share redemp tion. The Minister allowed the company to deduct only three-sevenths of the claimed expenses. The Minister took the position that four-sevenths, or $400,000, of the money borrowed through the issue of bonds was used by the company to redeem its preferred shares and not used for the purpose of earning income from its business; that interest on the $400,000 was therefore not deductible under section 11 (1)(c); . . .

The main portion of the judgment of the learned President reads as follows:

In 1956, the appellant investigated the possibility of raising further capital for expansion by way of bond issues and learned that one of the first steps that it would have to take was to redeem its preferred shares and substitute borrowed capital for the capital that had been subscribed for such preferred shares. Accordingly, in 1956, the appellant redeemed its preferred shares and, to do so, paid $700,000 to the holders of those shares. At the same time, it borrowed $700,000 from the Great West Life Assurance Company by way of a bond issue and raised a further $300,000 by issuing additional common shares. In the course of carrying out these transactions, the preferred shares were redeemed by using the $300,000 obtained by the new issue of common shares and $400,000 out of the $700,000 received on the floating of the bond issue.

In these circumstances, the question arises as to whether the appellant is entitled to a deduction, in computing its income for 1956 and subsequent years, of the whole or only part of the interest payable on such bonds by virtue of Section 11(1)(c) of the Income Tax Act, which reads as follows:

The respondent has disallowed the deduction of four-sevenths of the amount of such interest for each of the years in question on the ground that $400,000 out of the $700,000 borrowed by the bond issue was used to redeem preferred shares and was not, therefore, used “for the purpose of earning income” from the business. In this conclusion, the respondent has been upheld by the Tax Appeal Board.

The alternative view is that, prior to the transactions in question, the capital being used for the purpose of earning income from the appellant’s business was the $700,000 subscribed by the preferred shareholders and the $140,006 subscribed by the common shareholders, and that, after those transactions, the money subscribed by the preferred shareholders had been withdrawn and what the appellant was using in its business to earn income was the $440,006 subscribed by common shareholders and the $700,000 of borrowed money. This, in my view,* is a correct appreciation of the matter.

It follows that, in my view, the whole of the $700,000 of borrowed money was being used by the appellant in its business for the purpose of earning income from the business; and that is my view even though, from another point of view, and in a different sense, some $400,000 of the $700,000 was in fact paid on the redemption of the preferred shares.

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 DWS Corporation v MNR, [1968] 2 Ex CR 44; [1968] CTC 65 (affirmed Can SC), 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 DWS 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 the loan as long as its first use was in the business.

The facts of the present appeal provide an even more striking illustration of the inappropriateness of the meaning of the words “money used for the purpose of earning income from a business” that is relied on by the respondent. Prior to the 1956 transactions, the appellant’s capital used in its business consisted in part of $700,000 subscribed by preferred shareholders. As a result of those transactions, the $700,000 had been repaid to those shareholders and the appellant had borrowed $700,000 which, as a practical matter of business common sense, went to fill the hole left by redemption of the $700,000 preferred. Yet, according to the view relied on by the respondent, for the purpose of this provision concerning interest on borrowed capital, $400,000 of the borrowed money cannot be regarded as being used to earn income from the business.

The documents in the common evidence show that in each of the years the plaintiff owned a conglomerate of income-bearing assets amounting to more than $1,000,000, plus non-income bearing assets (principally the loans made to his children), and there was a large excess of income-bearing assets over the loans payable by the plaintiff and a large excess of assets over liabilities. Included in the incomebearing assets were investments in the private companies from which the plaintiff borrowed the amounts set forth in paragraphs 2 and 3 of the agreed statement.

Counsel for the plaintiff pointed to the excess above mentioned and argued that if the plaintiff had sold assets and lent the proceeds to his children and then had borrowed to replace such assets, the interest on the borrowed money would be deductible; the test of deductibility is not the first use to which the borrowed money is put, the test is the fundamental use of the money, and the current use to which it is put in each year is the determining consideration; the plaintiff had a freedom to use his assets to make loans to his children and to borrow for the purpose of filling the hole left by the making of such loans, and the interest each year on the borrowing is deductible.

Counsel for the Crown argued that the facts in the Trans-Prairie case are different from the facts in this case, for in the former case the financing by preferred shares was replaced by financing by means of borrowed money, whereas in the present case the plaintiff borrowed for the purpose of making loans to his children, not for the purpose of earning income, and the borrowed money was used for such loans; the fact that the plaintiff had an excess of assets over liabilities is of little consequence; and in fact the plaintiff borrowed the money for the purpose of making loans to his children and put the money to that use, and it was not used for the purpose of earning income. Counsel referred to the following cases: Commissioners of Inland Revenue v Wesleyan and General Assurance Society, 30 TC 11: Henriksen v Grafton Hotels Ltd, 24 TC 453; DWS Corporation v MNR, [1968] CTC 65; 68 DTC 5045; 69 DTC 5203; Auld v MNR, 28 Tax ABC 236; 62 DTC 27.

As I understand the learned President’s decision in the Trans-Prairie case he rejected, as a test of deductibility of interest under paragraph 11(1)(c), whether the first expenditure of the money after it was borrowed was an expenditure for the purpose of the business, for although the use of that test might produce the right result in most cases it might produce a wrong result in other cases, and he reasoned that what must have been intended by the section 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 the loan as long as its first use was in the business. There is in the rationale of that decision the rule that the borrowed money must be used for the purpose of earning income from the business, and the President’s appreciation of the matter in the Trans-Prairie case was that the appellant was using the borrowed money in its business to earn income. I do not think it follows from anything said in that judgment that on the facts in the present appeal it should be found that the borrowed money was either borrowed or was being used by the plaintiff to earn money from his business or property. On the contrary, my appreciation of the facts is that the money was borrowed and used by the plaintiff for the purpose of making non-interest bearing loans to his children, not for the purpose of earning income. He chose to find the money for the loans by borrowing, and the fundamental purpose of the borrowing was to make the loans.

The appeal is therefore dismissed, with costs to be taxed.