Livingston International Inc. v. The Queen, 91 DTC 5066, [1991] 1 CTC 155 (FCTD), aff'd 92 DTC 6197 (FCA)

Pinard, J.:—This is an appeal by the plaintiff from the reassessment made by the Minister of National Revenue, which served to deny International- Import Customs Brokers Inc. the right to deduct pursuant to subparagraph 20(1)(c)(i) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") the full amount of interest paid by the latter in respect of borrowed money in computing its income for the 1983 taxation year.

At trial, the parties filed an agreed statement of facts, supported by an agreed book of documents, to serve as the whole evidence in the present case. The agreed statement of facts states as follows:

1. By an agreement dated July 31, 1979, Jack Lamont, Joan Lamont, John Stewart and Kenneth Stephenson, shareholders of Import Customs Brokers Ltd. (hereinafter respectively called the "Shareholders" and "Import") agreed with Livingston Industries Ltd. (hereinafter called "LIL") that Import and International Customs Brokers Limited (hereinafter called International”), a wholly owned subsidiary of LIL, would amalgamate on August 17, 1979.

2. Prior to August 17, 1979:

(i) Import, which had been operating for approximately twenty (20) years, and International, which had been operating for approximately thirty (30) years, were competitors in the custom house brokerage and international forwarding business;

(ii) International had been a wholly owned subsidiary of LIL for approximately two (2) years.

3. On August 17,1979:

(i) Import amalgamated with International under the laws of the province of Ontario to form International-Import Customs Brokers Inc. (hereinafter called the" Inter-Import");

(ii) the Shareholders received, in exchange for an aggregate 100 common shares of Import, an aggregate of 100 first preference shares of Inter-Import of a par value of .25 cents each and 100,000 second preference shares of Inter-Import of a par value of 0.00075;

(iii) the Inter-Import shares held by the former shareholders were transferred under subsection 85(1) of the Income Tax Act to three separate holding companies, two of which were incorporated by the Shareholders specifically for that purpose;

(iv) each of the three holding companies then transferred the Inter-Import shares held by it to a second holding company called 422646 Ontario Limited.

4. On August 20, 1979:

(i) Inter-Import borrowed $6,000,000 from LIL;

(ii) the proceeds of the loan were then used to redeem on that same date, the first preference shares of Inter-Import held by 422646 Ontario Limited, for an aggregate amount of $6,000,000;

(iii) at that time, the aggregate paid-up capital of the issued first preference shares of Inter-Import, was $25.00 and the retained earnings of Inter-Import were $4,178,371, that is an aggregate amount of $4,178,396;

(iv) Inter-Import borrowed an amount of $3,000,000 from 422646 Ontario Limited which was evidenced by interest-bearing promissory notes;

(v) the proceeds of the $3,000,000 loan from 422646 Ontario Limited were used by Inter-Import to reduce the $6,000,000 outstanding indebtedness to LIL to an amount of $3,000,000.

5. On August 21, 1979, the second preference shares of Inter-Import were redeemed for an aggregate amount of $75.

6. As a result of the redemption of the first preference shares, 422646 Ontario Limited reported a taxable dividend of $5,999,975 which it deducted under subsection 112(1) of the Income Tax Act in computing its taxable income.

7. Interest payments were made by Inter-Import during the 1980, 1981, 1982 and 1983 taxation years on the indebtednesses as follows:

		422646
	LIL	Ontario	Total
Lender	loan	Ltd, loan
Amount of loan	3,000,000	3,000,000	6,000,000
Interest paid
-1980	403,125	318,979	722,104
-1981	364,127	316,783	680,910
-1982	276,800	287,865	564,665
-1983	117,625	262,507	380,132
Total	1,161,677	1,186,134	2,347,811

8. By a Notice of Determination of Loss dated February 28, 1986, in respect of ihe 1981 taxation year, and by Notices of Reassessment dated August 30, 1985, in respect of the 1980, 1981, 1982, 1983 and 1984 taxation years, the Defendant disallowed the following amounts claimed by Inter-Import as part of the interest expenses incurred by it in respect of the loans:

		422646
	LIL	Ontario	Total
	loan	Ltd, loan
Total claimed	1,161,677	1,186,134	2,347,811
Total disallowed	352,685	360,110	712,795
% disallowed	30.36%	30.36%	30.36%

9. The basis upon which the Minister proceeded in so reassessing the plaintiff is that the interest payable on the portion of the loans which exceeds the paid-up capital of Inter-Import's first preference shares and retained earnings at August 20, 1979, which portion represents an amount of $1,821,504 or 30.36% of the borrowed funds, is not interest the deduction of which is permitted under paragraph 20(1)(c) of the Income Tax Act.

10. The said Notification and Reassessments were confirmed by Notification of Confirmation dated June 22, 1987.

11. On December 31, 1985, the plaintiff, Border Brokers Inc., Livingston On-Line Brokerage Service Inc., Samson-Shaen & Co. Ltd., Airspeed Brokers (1962) Ltd. and Livingstonair Inc. were amalgamated under the laws of the Province of Ontario to form the plaintiff, Livingston International Inc.

This litigation thus involves Inter-Im port's right to deduct the full amount of interest paid in respect of the said borrowed funds in computing its income for the 1983 taxation year, pursuant to subparagraph 20(1)(c)(i) of the Act.

The plaintiff's view is that the entire amount of interest expense deducted by Inter-Import in the 1983 taxation year was incurred for the purpose of gaining or producing income from a business or property and accordingly, Inter-Import was entitled to deduct the full amount of interest paid in respect of the borrowed funds in computing its income for the 1983 taxation year.

Subparagraph 20(1)(c)(i) read at the relevant time as follows:

20.(1) 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) 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 to acquire a life insurance policy),

This legislative provision was the subject of consideration by the Supreme Court of Canada, in Bronfman Trust v. The Queen, [1987] 1 C.T.C. 117; 87 D.T.C. 5059, where Chief Justice Dickson (as he then was) assessed the purpose of the provision as follows, at 124-25 (D.T.C. 5064):

It is perhaps otiose to note at the outset that in the absence of a provision such as paragraph 20(1)(c) specifically authorizing the deduction from income of interest payments in certain circumstances, no such deductions could generally be taken by the taxpayer.. . .

I agree with Marceau, J. as to the purpose of the interest deduction provision. Parliament created subparagraph 20(1)(c)(i), and made it operate notwithstanding paragraph 18(1)(b), in order to encourage the accumulation of capital which would produce taxable income.. . .

The statutory deduction thus requires a characterization of the use of borrowed money as between the eligible use of earning non-exempt income from a business or property and a variety of possible ineligible uses. The onus is on the taxpayer to trace the borrowed funds to an identifiable use which triggers the deduction.. . .

The interest deduction provision requires not only a characterization of the use of borrowed funds, but also a characterization of "purpose". Eligibility for the deduction is contingent on the use of borrowed money for the purpose of earning income. It is well established in the jurisprudence, however, that it is not the purpose of the borrowing itself which is relevant. What is relevant, rather, is the taxpayer's purpose in using the borrowed money in a particular manner: Auld v. M.N.R., 28 Tax A.B.C. 236; 62 D.T.C. 27 (T.A.B.). Consequently, the focus of the inquiry must be centered on the use to which the taxpayer put the borrowed funds.

Chief Justice Dickson went on to emphasize the necessity to look at the direct use to which a taxpayer puts borrowed money, reaffirming the reluctance of the Supreme Court of Canada to overlook a clearly ineligible direct use of borrowed money whenever an indirect eligible use of funds can be found. In that regard, at pages 126-28 (D.T.C. 5065-66), he stated the following:

In my view, neither the Income Tax Act nor the weight of judicial authority permits the courts to ignore the direct use to which a taxpayer puts borrowed money.. . .

One finds in the Act not only the distinction within subparagraph 20(1)(c)(i) 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. Subsection 20(3) (formerly subsection 11 (3b)) 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 subsection 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 to repay a loan and not to earn income: Interior Breweries Ltd. v. M.N.R., [1955] C.T.C. 143 at 148; 55 D.T.C. 1090 at 1093 (Exch. Ct.).

It is not surprising, therefore, that the cases interpreting subparagraph 20(1)(c)(i) and its predecessor provisions have not favoured the view that a direct ineligible use of borrowed money ought to be overlooked whenever an indirect eligible use of funds can be found. . . .

The leading case from this Court on the availability of the interest deduction, Canada Safeway Ltd. v. M.N.R., also demonstrates a reluctance to overlook a clearly ineligible direct use of borrowed money in order to favour the taxpayer by characterizing the transaction on the basis of a less direct eligible use of borrowings. . . . Justice Rand stated, at 726 (C.T.C. 343):

No doubt there is in fact a causal connection between the purchase of the stock and the benefits ultimately received; but the statutory language cannot be extended to such a remote consequence; it could be carried to any length ina chain of subsidiaries; and to say that such a thing was envisaged by the ordinary expression used in the statute is to speculate and to interpret.

Referring to the interest expense deduction for borrowed money used for the purpose of earning income from business, Rand, J. concluded at 727 (C.T.C. 345):

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.

Proper interpretation of subparagraph 20(1)(c)(i) of the Act, therefore, requires that a taxpayer, before he or she can deduct interest expenses:

(a) trace the borrowed funds to an identifiable use which triggers the deduction; and

(b) generally demonstrate that the borrowed funds were used directly and immediately to earn income from a business or property; the purpose of the provision being to” encourage the accumulation of capital which would produce taxable income.”

In the case at bar, in spite of the fact that the borrowed money was used by a company to redeem its shares and thus, was not directly used to earn income, the plaintiff argued that the interest paid on the relevant loans still ought to be deductible based on Trans-Prairie Pipelines Ltd. v. M.N.R., [1970] C.T.C. 537; 70 D.T.C. 6351, a decision of Jackett, P. in the Exchequer Court, which was also referred to in the Bronfman Trust case, supra, and summarized as follows, at page 122 (D.T.C. 5062):

In that case the taxpayer corporation wanted to raise capital byway of bond issues for expansion of its business. It discovered, however, that it was impossible, practically speaking, to float a bond issue unless it first redeemed its preferred shares, because of the sinking fund requirements of its preferred share issue. Accordingly, the taxpayer borrowed $700,000, used $400,000 to redeem the preferred shares and the remaining $300,000 for expansion of its business. Jackett P. held the interest payments on the entire $700,000 loan deductible. He saw the borrowed funds as "fill[ing] the hole left by the redemption".

[Emphasis added.]

Indeed, in Trans-Prairie, supra, the relevant view, based on specific and particular facts, was expressed as follows, at page 539 (D.T.C. 6353):

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.

[Emphasis added.]

In its consideration of the Trans-Prairie case, the Supreme Court of Canada, in Bronfman Trust, did not go farther than to agree to the fact that in that case "the money previously subscribed by preferred shareholders had been used by the company for the purpose of earning income from the business” (page 124 (D.T.C. 5063)) and to find "perfectly correct in so far as it goes" the proposition "that it is the current use and not the original use of borrowed money that determines eligibility for a deduction” (page 128 (D.T.C. 5066)). Finally, the Supreme Court of Canada only referred to the Trans-Prairie case to state, at page 128 (D.T.C. 5066):

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 but ineligible uses of borrowed money.

In light of the Bronfman Trust decision, it would seem to me that one cannot infer from the Trans-Prairie case that interest on borrowed money used to redeem shares is generally deductible.

Here, in the context of a series of quasi-instantaneous transactions where it cannot really be said that the borrowed funds are used to fill a hole left by the "withdrawal" of funds previously used in the borrower's business, it is rather doubtful that the Trans-Prairie reasoning can be applied. It is in any event clear that the excess of borrowed funds over the retained earnings and the paid-up capital of the plaintiff as of August 20, 1979 cannot constitute within the reasoning of Trans-Prairie a replacement of capital which has already been used in the business. I consider, therefore, that the plaintiff has failed to show that such excess of borrowed funds was used at the relevant time for the purpose of earning income from a business or property, and that the interest paid thereon ought not to be deducted pursuant to subparagraph 20(1)(c)(i) of the Act.

Consequently, the plaintiff's action must be dismissed with costs.

Appeal dismissed.