Date: 20100114
Docket: A-81-09
Docket: A-82-09
Citation: 2010 FCA 12
CORAM: BLAIS
C.J.
SHARLOW
J.A.
PELLETIER
J.A.
Docket: A-81-09
BETWEEN:
FLEURETTE COLLINS
Appellant
and
HER MAJESTY THE QUEEN
Respondent
Docket: A-82-09
BETWEEN:
EUGENE COLLINS
Appellant
and
HER MAJESTY THE QUEEN
Respondent
REASONS FOR JUDGMENT
SHARLOW J.A.
[1]
This is an
appeal of two judgments of Justice V. Miller of the Tax Court of Canada disposing
of income tax appeals of the appellants Fleurette and Eugene Collins for the
years 1993, 1994, 1995 and 1996. The reasons for judgment are reported as Collins
v. Canada, 2009 TCC 56. The income tax appeals succeeded in respect of
issues conceded by the Crown, but were otherwise dismissed. Mr. and Mrs.
Collins are now appealing to this Court on the one issue on which they did not
succeed in the Tax Court.
[2]
The one
issue remaining in dispute relates to the deductibility of interest on a particular
debt for 1994, 1995 and 1996. It is undisputed that the appellants were jointly
liable for the principal amount of the debt in the amount of approximately $1.5
million. They each claimed deductions of $77,186 for 1994, $80,127 for 1995 and
$84,391 for 1996, representing 50% of the interest accrued in those years at
the rate of 10%. The Minister reduced each of those deductions to $10,000 based
on his conclusion that, according to the contractual terms governing the debt,
the appellants’ joint legal obligation in each 1994, 1995 and 1996 was to pay interest
of $20,000 but no more.
[3]
The relevant
statutory provision is paragraph 20(1)(c) of the Income Tax Act,
R.S.C. 1985, 1 (5th. Supp.) c.1, which reads in relevant part as
follows:
|
20. (1) [. . .] 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
|
20. (1) [. . .] sont
déductibles dans le calcul du revenu tiré par un contribuable d’une entreprise ou d’un
bien pour une année d’imposition celles des sommes suivantes qui se
rapportent entièrement à cette source de revenus ou la partie des sommes suivantes
qu’il est raisonnable de considérer comme s’y rapportant :
|
|
[. . .]
|
[. . .]
|
|
(c) an amount paid
in the year or payable in respect of the year (depending on the method
regularly followed by the taxpayer in computing the taxpayer’s 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 [. . .],
or a reasonable amount in respect
thereof, whichever is the lesser [. . .].
|
c) la moins élevée d’une somme payée au cours de l’année ou payable pour
l’année (suivant la méthode habituellement utilisée par le contribuable dans
le calcul de son revenu) et d’une somme raisonnable à cet égard, en exécution
d’une obligation légale de verser des intérêts sur :
(i) de l’argent emprunté
et utilisé en vue de tirer un revenu d’une entreprise ou d’un bien [. . .].
|
[4]
The facts
are fully set out in the reasons for the judgment under appeal. For the
purposes of this appeal only a summary is necessary. The facts are undisputed
except for one point, which is mentioned below.
[5]
In the
early 1980s the appellants, as equal partners, borrowed approximately $1.8
million from an Alberta crown corporation for the
purpose of constructing an apartment building to be made available to low
income tenants. The loan was secured by a mortgage on the property. The terms
of the loan stipulated an interest rate of 8.75% and required monthly payments
of $13,368.32. Between 1984 and 1991, amounts of interest were capitalized or
deferred pursuant to various formal and informal arrangements.
[6]
In 1991,
the Alberta government decided to
terminate the program under which the loan had been made. From 1991 to 1993,
the appellants negotiated with an Alberta
government agency to restructure the financing. By the time an agreement was
reached, the amount of the loan (including capitalized interest) had increased
to almost $2.7 million.
[7]
Under an
agreement entitled “Loan Agreement and Mortgage Amending Agreement” dated July
22, 1993 (referred to in the reason for judgment as the “Amending Agreement”), an
Alberta government agency lent the
appellants $1.2 million to be applied against the original debt, leaving a
balance of approximately $1.5 million. The new $1.2 million loan was secured by
a new mortgage ranking ahead of the previous mortgage. No tax issue arises in
relation to that new loan.
[8]
The
contractual terms of the mortgage agreement governing the original loan were
amended by the Amending Agreement. Paragraphs 13 and 14 of the Amending
Agreement provide that it does not constitute an accord and satisfaction with
respect to the existing debt, or a novation.
[9]
Paragraph
6 of the Amending Agreement sets out the amended terms relating to interest and
payments on the debt. It reads in relevant part as follows (Appeal Book, page
230):
|
i)
|
TERM:
|
20 years from AUGUST 1, 1993;
|
|
(ii)
|
INTEREST:
|
10% simple interest to be calculated
and paid annually on AUGUST 1st of each year subject to the payment provision
below for the first 15 years of the term;
|
|
(iii)
|
PAYMENTS:
|
Minimum annual interest payments of
$20,000.00 for each of the first 15 years of the amended term due on or
before AUGUST 1st of each year. At the end of the 16th year of the term, any
remaining unpaid accrued interest is immediately due and payable and
thereafter, interest shall be paid in accordance with subparagraph (ii)
above. The principal sum outstanding shall be paid on or before JULY 31,
2013;
|
|
(iv)
|
EARLY PAYOUT:
|
The Borrower may at its option, at any
time, up to JULY 31, 2008, pay all interest and principal monies outstanding
upon payment of the sum of $100,000.00 plus payment of all the FIFTEEN (15)
minimum $20,000.00 annual interest payments unpaid which total payment shall
be applied firstly to all outstanding interest due to the date of early
payment and secondly to principal.
|
[10]
The parties
do not agree on how to interpret paragraph 6 of the Amending Agreement. The Judge
adopted the Crown’s interpretation, discussed later in these reasons.
[11]
The
appellants report their income on the accrual basis. As mentioned above, when filing
their income tax returns for 1994, 1995 and 1996, the appellants each claimed
50% of the full amount of interest accrued on the loan at 10%, the rate
stipulated in paragraph 6 of the Amending Agreement.
[12]
The
Minister took the position that the appellants had no legal obligation, in the
years under appeal, to pay interest on the loan in excess of the $20,000
stipulated in subparagraph 6(iii) of the Amending Agreement. On that basis, he
limited the interest deductions for each of those years to $10,000 for Mr.
Collins and $10,000 for Ms. Collins. The appellants objected and appealed to
the Tax Court. The Judge agreed with the Minister and dismissed their appeal on
that point.
[13]
The Tax
Court trial was held in April of 2008. Mr. Collins testified that, as of that
time, the appellants had made all of the annual $20,000 payments except the
last one, which was due on August 1, 2008, and that they intended to exercise
the subparagraph 6(iv) option (which I will refer to as the “settlement option”).
Mr. Collins also testified that, because the rental market had improved in the
preceding four years, he thought they would have the money to exercise the settlement
option by July 31, 2008.
[14]
It is
useful at this point to mention the one fact that is in dispute. The appellants
argue that the Judge made a palpable and overriding factual error at paragraph
17 of her reasons, where she indicates that the appellants agreed at the trial
that the interest to which subparagraph 6(ii) of the Amending Agreement refers
was not paid and that it would never be paid. The appellants say that this
statement is not an accurate reflection of the evidence of Mr. Collins, which
is summarized above. I agree. However, in my view nothing turns on this factual
error. It is irrelevant to the issues in dispute in this case whether and when
the appellants formed the intention to exercise the settlement option, or
whether they had the means to do so at any point in time.
Interpretation of paragraph 6 of the
Amending Agreement
[15]
The interpretation
of a contract is a question of law: see MacNeil v. Canada (Employment
Insurance Commission, 2009 FCA 306 at paragraph 26, and the cases
cited in that paragraph. For that reason, this issue must be reviewed on the
standard of correctness.
[16]
The
interpretation proposed by the Crown is that the only legal obligation of the
appellants during the first fifteen years of the term of the amended loan
agreement was to pay $20,000 on August 1 of each year on account of interest
accrued during that year. Any obligation to pay interest in excess of $20,000
per year would arise only after July 31, 2008, and then only if the appellants
failed to exercise the settlement option by paying $400,000 less the total of
the $20,000 annual payments previously made.
[17]
The
Judge accepted the interpretation proposed by the Crown. In my respectful view,
she erred in law in doing so because that interpretation is not consistent with
the language of paragraph 6 of the Amending Agreement and with the agreement as
a whole.
[18]
In substance,
the Crown’s argument is that during the first 15 years of the term, the
appellants’ obligation to pay the excess amount was only a contingent
obligation that would become an absolute obligation only if, by July 31, 2008,
the appellants failed to exercise the settlement option. However, reading
paragraph 6 in its entirety, it is apparent that the provisions governing the
due date for payment of interest and principal are the same, in that the
principal and all unpaid interest is stated to be due on a future date subject
to the exercise of the settlement option requiring payments totalling $400,000
for all principal and interest. In my view, the Crown has mistaken what is
contingent. It is not the appellants’obligation to pay the interest that is contingent,
but the appellants’ right to exercise the settlement option.
[19]
It follows
that, in each of the years under appeal (1994, 1995 and 1996) and indeed for
each of the first 15 years of the term of the Amending Agreement, the
appellants had a non-contingent obligation to pay interest accrued on the
approximately $1.5 million principal amount of the debt at the rate of 10% as
stipulated in subparagraph 6(ii) of the Amending Agreement.
Interpretation of paragraph 20(1)(c)
of the Income Tax Act
[20]
The next
question is whether the appellants had a legal obligation during the years under
appeal to pay the full amount of the interest accrued during those years, even
though the due date did not occur in those years and would not occur if the
appellants exercised the settlement option. The Judge determined this question
in the Crown’s favour on the basis that a taxpayer cannot be said to have a
legal obligation that is “payable” in a particular year if the due date of the
obligation falls in a subsequent year. In my view, that conclusion is based on
an incorrect understanding of meaning of “payable” as used in paragraph 20(1)(c)
in the phrase “payable in respect of the year”.
[21]
The interpretation
of the opening words of paragraph 20(1)(c) has been settled for many
years. It has long been accepted that if a taxpayer borrows money for the
purpose of earning non-exempt income from a business or property and has, as in
this case, a non-contingent legal obligation to pay interest on that debt, the
taxpayer may deduct the interest.
[22]
It is also
well settled that the timing of the deduction depends upon whether the taxpayer
computes income on the cash basis or the accrual basis. If the taxpayer computes
income on the cash basis, the permissible deduction in a particular year is the
amount of interest paid in that year. If the taxpayer computes income on the
accrual basis, the permissible deduction in a particular year is the amount of
interest accrued in respect of that year, whether or not the interest was paid
or fell due in that year. The law on this point is correctly summarized in
paragraphs 5 and 6 of Interpretation Bulletin IT-533, Interest Deductibility
and Related Issues, dated October 31, 2003.
[23]
It is very
common, for example, for a commercial debt to require interest accrued in one
year to be paid in a later year. If the borrower is an accrual basis taxpayer,
the interest deduction is properly made in the year of accrual. Indeed, if the
deduction is not made in that year it can never be made; see M.N.R. v. Mid-West
Abrasive Company of Canada Ltd., 73 D.T.C. 5429 (F.C.T.D.).
[24]
In this
case the appellants are accrual basis taxpayers. Therefore, they are entitled
to deduct interest as it accrues, regardless of the date on which payment is
due. The appellants correctly claimed deductions for interest accrued at the
rate of 10% per year as stipulated in paragraph 6(ii) of the Amending Agreement.
They are entitled to that deduction even though they were not obliged to pay
the full amount of the interest in the year of accrual, and even though the
lender would be obliged, if the appellants exercised the settlement option, to
forgive most of the obligation to pay principal and interest.
[25]
The
situation is analogous to that of a limited recourse mortgage loan, where the
right of the lender to recover the principal and interest is limited to the
proceeds of sale of the mortgaged property at the end of the term. Even if it
is absolutely certain that the value of the property will not cover the
mortgage debt, the full amount of the debt remains a legal obligation of the
borrower unless and until the mortgaged property is sold (see, for example, Canada
v. McLarty, [2008] 2 S.C.R. 79, 2008 SCC 26).
The reasonableness test in paragraph
20(1)(c) of the Income Tax Act
[26]
The Judge
agreed with the Crown that the amount of the interest deductible under
paragraph 20(1)(c) must be limited to $20,000 because to permit any
greater deduction would not be reasonable. That conclusion is intended to be an
application of the words of paragraph 20(1)(c) that limit any interest
deduction to the interest payable or “a reasonable amount in respect thereof”,
whichever is less.
[27]
The
Crown’s pleadings put the appellants on notice that they would be required to
establish that the interest in question met the requirements of paragraph
20(1)(c), but only in relation to the question of whether the appellants
had a legal obligation, in the years under appeal, to pay interest at the rate
stipulated in paragraph 6 of the Amending Agreement. The Crown did not plead
the issue of reasonableness and did not mention the issue of reasonableness
until closing arguments at trial.
[28]
In Shell
Canada Ltd. v. Canada, [1999] 3 S.C.R. 622, at paragraph 28, Chief Justice
McLachlin, writing for the Court, explained that one of the elements of
paragraph 20(1)(c) is that the amount of the deduction claimed must be
reasonable, as assessed by reference to the first three requirements. In that
regard, she explained at paragraph 34 that an interest rate established in a
market of lenders and borrowers acting at arms’ length is generally a
reasonable rate. This suggests that, in determining the reasonableness of an
interest deduction, it is relevant to consider evidence of external factors
such as market conditions and market rates for comparable transactions.
[29]
When the
Crown failed to plead reasonableness and raised that issue for the first time
in closing argument at trial, the appellants were unfairly prejudiced because
they could not have known, until after the evidence was presented, that
evidence relating to the reasonableness of the interest rate could be relevant.
The appellants argued at trial that the reasonableness argument should not be
entertained, but the Judge rejected that argument. In my view, she erred in law
in doing so because of the resulting prejudice to the appellants.
[30]
Even if
the Tax Court Judge had been correct to permit the reasonableness test to be
argued, she did not apply the test correctly. At paragraph 38, she explains her
view that the deduction of interest is unreasonable if the interest was not
paid in the year under appeal and did not have to be paid in the year under
appeal. That is not only inconsistent with the comments in Shell
relating to the reasonableness test, it renders most of paragraph 20(1)(c)
redundant.
Conclusion
[31]
For these
reasons, I would allow the appeal, set aside the judgments of the Tax Court
and, making the judgments that should have been made, I would allow the
taxpayers’ appeals and refer the reassessments back to the Minister for reassessment
on the basis that the appellants are entitled to deduct all interest accrued on
the loans in the amounts they originally claimed.
Costs
[32]
The
appellants have asked for costs in this Court and in the Tax Court. They have
also asked for costs on an increased scale because of the Crown’s improper
attempt to raise a new issue for the first time in argument at trial.
[33]
The
request for increased costs was not mentioned in the appellants’ memorandum of
fact and law, but was raised for the first time only in argument at the appeal,
thus taking the Crown by surprise. The appellants should have indicated in the
memorandum that they were seeking costs on an increased scale, or alternatively
indicated at the hearing of the appeal that if successful, they would bring a
motion under Rule 400 for a direction that costs be awarded on an increased
scale.
[34]
In any
event, I am not persuaded that an award on a higher than normal scale is
justified in this case. The reasonableness argument failed on its merits and so
no actual prejudice resulted.
[35]
I would
award the appellants their costs in this Court on the ordinary scale, and their
costs in the Tax Court.
“K. Sharlow”
“I
agree.
Pierre Blais C.J.”
“I
agree.
Pelletier
J.A.”
Email this Content