C.R.B. Logging Co. v. R, 99 DTC 840, [1999] 2 CTC 2279 (TCC), aff'd , 2000 DTC 6547, Docket: A-242-99 (FCA)

Sarchuk T.C.J.:

These are appeals by C.R.B. Logging Co. Ltd. (CRB) from assessments of tax with respect to its 1991 and 1992 taxation years whereby the Minister of National Revenue (the Minister) disallowed interest expenses claimed in the amounts of $129,536 and $53,149, respectively.

The Appellant, CRB, is a private company incorporated under the laws of British Columbia. At the relevant time, its only assets were a Forest Licence, operating equipment, roads and bridges presently constructed in or about its logging operations, log inventories and a contract with McMillan- Bloedel Ltd. Tyee Management Ltd. (Tyee) and Pemberton Valley Holdings Ltd. (Pemberton) were the registered and beneficial holders of all the issued and outstanding shares of CRB as at April 29, 1988. Tyee and Pemberton had no assets other than the shares of CRB. [1]

Meager Creek Holdings Ltd. (Meager) was incorporated on January 15, 1988 by Ken Pickering (Pickering) and Paul Turner (Turner). The sole shareholders of Meager were Pickering, Turner and their wives. Turner and Pickering were also its directors. The authorized capital of Meager consisted of 10,000 common shares without par value and 5,000,000 preferred shares with a par value of $1.00 each.

On April 29, 1988, Meager entered into a share purchase agreement to acquire all of the outstanding shares of Tyee and Pemberton for $3,885,000. To enable Meager to complete the transaction, Pickering and Turner each advanced $1,000,000 to Meager (secured by promissory notes). The balance of $1,885,000 remained outstanding since Meager was not able to obtain financing from the Canadian Imperial Bank of Commerce (CIBC) because it was a newly incorporated company and had no assets beyond the monies borrowed by it from Turner and Pickering. CIBC did, however, agree to make a loan to CRB as it had sufficient assets to secure such a loan.

The acquisition of Tyee and Pemberton by Meager was completed on April 29, 1988. Concurrently, Turner and Pickering were appointed directors of CRB. On May 4, 1988, CRB subscribed for 1,885,000 of Meager’s preferred shares. On May 5, 1988, CRB received a loan from CIBC in the amount of $1,885,000 (the May 1988 loan) enabling CRB to purchase the preferred shares of Meager. Various guarantees were given by and on behalf of CRB to CIBC in order to secure the loan. On May 6, 1988, Meager issued a Notice of Allotment, allotting 1,885,000 preferred shares to CRB and confirming the receipt of $1,885,000 in payment. On the same day, Meager used these funds to pay the outstanding balance on its acquisition of the Tyee and Pemberton shares under the share purchase agreement.

In July 1988, Meager purchased 50% of the outstanding shares (200 common shares) of Ogden Lumber Co. Ltd. (Ogden Lumber), a road maintenance contracting company. This investment constituted less than 1% of Meager’s total investments during the fiscal period ending March 31, 1989. No investments were made by Meager during the taxation years in issue.

On April 28, 1989, CRB declared dividends to each of Tyee and Pemberton in the amounts of $250,000. In turn, Tyee and Pemberton each declared dividends in favour of Meager in the same amounts. The dividend declared by CRB was accounted for in the books of Tyee and Pemberton as a “receivable”. Meager, for its part, recorded the dividends from Tyee and Pemberton as a “receivable”. On April 28, 1989, CRB, by way of ajournai entry, recorded a payment of $250,000 on behalf of Tyee and $250,000 on behalf of Pemberton to Meager. Meager then made arrangements to lend the sum of $500,000 to CRB. No cash or cheques were exchanged, the transaction being recorded at year end by way of journal entry. On February 15, 1990, CRB declared a dividend of $250,000 to each of Tyee and Pemberton. On the same date, Tyee and Pemberton each declared a dividend of $900,000 to Meager representing the retained earnings of these companies after receipt of the dividends from CRB. Also, on the same date, Meager advanced the sum of $1,800,000 by way of loan to CRB. As a result of these transactions, CRB was indebted to Meager as at December 1990 in the amount of $1,885,000 (the shareholder’s loan).

In or about November 1990, an arrangement was made by Pickering and Turner to sell ’A of the shares of both Tyee and Pemberton to 387897 B.C. Ltd. for consideration of $l,200,000. [2] On December 21, 1990, in anticipation of this transaction, CRB forwarded a cheque to CIBC in the amount of $1,850,000 with instructions that this cheque be deposited to the account of Meager on December 27, 1990 in satisfaction of the outstanding shareholder’s loan. This was accomplished by overdrawing CRB’s current account at CIBC by this amount (the overdraft). In the same letter to CIBC, a cheque was enclosed from Meager in the amount of $1,885,000 with instructions that it be deposited into CRB’s account on December 28, 1990. The purpose of this transaction was to permit Meager to redeem the preferred shares held by CRB in the sum of $1,885,000. In turn, CRB used the proceeds from the redemption to repay the May 1988 loan with CIBC, the balance of which owing at that time was $1,557,000, and applied the remaining funds to the overdraft created when CRB extinguished the shareholder loan. The payment towards the overdraft reduced its balance to $1,557,000. CRB then arranged for a new loan from CIBC in the amount of $1,557,000 (the December 1990 loan) in order to cover the remaining balance of the overdraft. [3]

CRB sought to deduct interest expenses related to the May 1988 and December 1990 loans in its 1991 and 1992 taxation years pursuant to subparagraph 20( 1 )(c)(i) of the Income Tax Act (the Act). These deductions were disallowed by the Minister.

Analysis

The issue to be determined is whether the Appellant was entitled to the deductions claimed in the 1991 and 1992 taxation years with respect to in- terest expenses incurred on the May 1988 and December 1990 loans. The relevant provisions of the Act provide:

8(1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property;

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) 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),

Subparagraph 20( 1 )(c)(i) establishes three conditions for deductibility: the interest must be paid or payable pursuant to a legal obligation to pay interest on the borrowed funds, the borrowed money must be used for the purpose of gaining or producing income from a business or property, and the borrowed funds cannot be used to earn income that is tax-exempt.

The decision of the Supreme Court in Bronfman Trust v. Æ., [4] established that the basic purpose of subparagraph 20( 1 )(c)(i) is to encourage the accumulation of capital which would produce taxable income. More specifically, Dickson C.J. observed that there were both eligible and ineligible uses of borrowed funds which affect deductibility under this subparagraph. He further noted that:

...Not all borrowing expenses are deductible. Interest on borrowed money used to produce tax exempt income is not deductible. Interest on borrowed money used to buy life insurance policies in not deductible. Interest on borrowings used for non-income earning purposes, such as personal consumption or the making of capital gains is similarly not deductible. 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. Therefore, if the taxpayer commingles funds used for a variety of purposes only some of which are eligible he or she may be unable to claim the deduction: see, for example, Mills v. M.N.R., 85 D.T.C. 632 (T.C.C.); No. 616 v. M.N.R., 59 D.T.C. 247 (T.A.B.).

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., 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. [5]

The Appellant’s position in this case is three-fold. First, the funds it borrowed from CIBC in May 1988 were used for the purpose of acquiring preferred shares of Meager, which was an eligible purpose i.e. the earning of income from property. Since there was no restriction on the dividend entitlement available on the preferred shares, this borrowing was a direct eligible use. Counsel argued that the failure to pay a dividend was by itself not fatal to the deductibility of the interest expense since Meager had the potential to earn income in the future and thus create a dividend income stream for CRB that would exceed the borrowing expenses incurred. This was sufficient for the purposes of the relevant provisions of the Act.

I am unable to accept the proposition that CRB borrowed the amount of $1,885,000 from CIBC for the bona fide purpose of earning dividend income from property by way of purchasing preferred shares in Meager. While there was some evidence from Pickering of an investment by Meager in Ogden Lumber, its income producing capacity was, for all practical purposes, negligible. There could be no realistic expectation of dividend income from the preferred shares because Meager had no income source of substance independent of the existence of CRB’s business. The true purpose of the May 1988 loan was to enable Meager to finance its purchase of the Tyee and Pemberton share and thereby to indirectly acquire CRB. In essence, CRB financed its own acquisition. The Lessard c. Ministre du Revenu national® [6] decision referred to by Counsel for the Appellant is distinguishable and provides little support for its case. In Lessard, the taxpayer attempted to deduct interest on funds borrowed in order to purchase preferred shares of a corporation of which he was the sole shareholder. That corporation was in effect a holding company with investments in an active business which the taxpayer did not own. As contrasted to the present appeals, the holding company in Lessard had a source of income independent from the taxpayer. CRB is not entitled to a deduction for interest paid on these borrowed funds since they were not directly used for the purpose of earning income from property.

In the alternative, Counsel for the Appellant argued that if the Court were to conclude that the true or economic purpose of the borrowing was the funding of Meager to permit it to acquire the shares of CRB (through Tyee and Pemberton) then this purpose is equally an eligible purpose since it too was undertaken in order to earn income from business or property. More specifically, according to Counsel, CRB prospered as a result of Meager’s acquisition of its shares, it was revitalized, it prospered, obtained new timber licences, all of which would not have occurred without the borrowing by CRB because Meager did not have the wherewithal to borrow the necessary funds itself. As Counsel observed “so it’s an acquisition that could not have occurred without the borrowing of the money by CRB”.

In 74712 Alberta Ltd. v. Minister of National Revenue,’ [7] Robertson J.A. observed that:

The above extracts render it clear that the direct-use rule has two prongs. First, it is necessary to trace the borrowed funds to an eligible use, that is, to an incomeproducing source, whether it be from a business or property. Second, there must be a sufficiently direct connection between the use of the borrowed funds and the source of income. Thus, even in cases where the borrowed funds are used for a purpose which has the indirect effect of enhancing the taxpayer’s incomeearning capacity, the interest payments remain non-deductible. The incomeearning purpose is simply too remote.

Meager was a new company, it had no independent income stream and did not itself have the ability to generate business or property income which could flow to the Appellant in the form of dividends. Although CRB may have, in a general sense, benefited from its acquisition by Meager, the ensu- ing economic benefits are too remote to constitute an eligible purpose within the meaning of the relevant provisions of the Act.

In the further alternative, Counsel for the Appellant argued that if it was concluded that the purpose of the funding of Meager by the Appellant was “too remote from an income-earning process” then the loans should be considered as being within the exceptional circumstances category postulated by the Supreme Court in Bronfman Trusté [8] Counsel contended that the funds were borrowed by CRB for business or economic reasons and not to preserve other income producing assets as was the case in Bronfman or in an effort to shelter income from tax.

Robertson J.A. considered this category in 747/2 Alberta Ltd. [9] and cited the following four reasons for its existence:

First, the exceptional category accords with the object and purpose of paragraph 20( I )(c)(i). Second, recognition of the exceptional category does not negate the policy objective underlying the existence of the direct-use rule. Third, the Supreme Court in Bronfman did not expressly overrule Trans-Prairie Pipelines Ltd. v. M.N.R., [1970] C.T.C. 537 (Ex. Ct.). In that case it was held that the taxpayer could deduct from income interest payments on funds borrowed for what may be regarded as an indirect eligible use. Fourth, the exceptional category accords with the directive found in Bronfman that transactions be viewed with an eye to “commercial realities”....

Robertson J.A. also observed that:

...the reasoning of the Supreme Court leaves open the possibility of recognizing exceptions to the direct-use rule. At the very least the law should be willing to consider the question of deductibility of interest in cases where it can be shown that the application of the direct-use rule would not serve its intended purpose. I turn now to the difficult question of what criteria are to be applied when circumscribing the boundaries of the exceptional category.

E) The Scope Of The Exceptional Circumstances Category

Having accepted that Bronfman did not preclude recognition of exceptions to the direct-use rule, under the umbrella of an exceptional circumstances category, it is still necessary to isolate the criteria to be applied when determining whether interest payments on funds borrowed for a direct ineligible use are deductible from income. In Bronfman, Dickson, C.J. mentions only two requirements: that the taxpayer establish a bona fide purpose (intention) to use the funds to earn income and a reasonable expectation that the borrowing transaction would yield income in excess of the interest expense.^ [10]

1 am unable to accept the Appellant’s position that its use of the borrowed funds to finance Meager’s acquisition of CRB was a bona fide purpose because it was intended that CRB’s acquisition would ultimately improve its own income flow. As was observed by Counsel for the Respondent, the closed nature of the income flow made it virtually impossible for CRB to receive dividends that did not originate from its own business activities. Hence, logic suggests that CRB could not have had a reasonable expectation that the borrowing transaction would yield income in excess of the interest expense. In this context, income must mean income from Meager arising from sources independent of CRB. That is particularly the case here since CRB had no control over Meager given that its Articles of Incorporation state that the holders of the preferred shares were not entitled to receive notice of or to attend and vote at meetings of the shareholders of Meager. As well, the directors of Meager at all times, had in their complete discretion the right to declare dividends on the common shares without the necessity of declaring a dividend in priority or at all on the preferred shares. [11]

I have concluded that CRB is not entitled to deduct the interest payments because the May 1988 borrowing transaction does not satisfy the direct use rule. Furthermore, there is no basis upon which to invoke the exceptional circumstances qualification. Since the December 1990 loan was undertaken for the purpose of replacing the May 1988 loan and therefore is ascribed the ineligible purpose of the May 1988 loan pursuant to subsection 20(3) of the Act. Thus, interest on both loans is not deductible.

In addition, I must note that the Meager preferred shares were redeemed on December 27, 1990 and in result, the income source to which the interest expenses were related no longer existed. As was observed in Emerson v. R. [12] where the source has been terminated the interest expense is no longer deductible.

For the foregoing reasons, the appeals are dismissed, with costs.

Appeal dismissed.