Ludmer v. Ministre Du Revenu National, 99 DTC 5153, [1999] 3 CTC 601 (FCA), rev'd supra

Marceau J.A.:

I have had the advantage of reading the reasons for judgment that my colleague, Létourneau J.A., has prepared to announce his decision and explain the reasoning behind it. Unfortunately, I fail to be persuaded by his approach and must, with respect, express a differing opinion. Now that the principal facts of the case are known and I am in a position to offset my views against his, I should be able to do it relatively briefly.

So we are yet again faced with a problem of application of the exceptional possibility of deducting interest under subparagraph 20(1 )(c)(i) of the Income Tax Act, a problem that has given rise to a number of major judicial rulings and has been the topic of much comment in the law reviews. It could be useful to read again right now and keep before us the text of this provision of the Act:

20.(1) Nonobstant les dispositions des alinéas 18(1)a), b) et h), lors du calcul du revenu tiré par un contribuable d’une entreprise ou d’un bien pour une année d’imposition, peuvent être déduites celles des sommes suivantes qui se rapportent entièrement à cette source de revenus ou la partie des sommes suivantes qui peut raisonnablement être considérée comme s’y rapportant

[...]

c) une somme payée dans l’année ou payable pour l’année (suivant la méthode habituellement utilisée par le contribuable dans le calcul de son revenu), 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 (autre que l’argent emprunté et utilisé pour acquérir un bien dont le revenu serait exonéré d’impôt ou pour prendre une police d’assurance-vie),

[..J

ou une somme raisonnable à cet égard, le moins élevé des deux montants étant à retenir.

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 hereto:

(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),

[.J

or a reasonable amount in respect thereof, whichever is the lesser.

It is unnecessary to repeat anew the detailed account of the facts in the case at bar. We have it in the trial judgment and my colleague has cited the relevant particulars.

The appellants are in essence seeking to deduct from their respective incomes the interest they paid on five loans they took out between September 1977 and June 1979 for the purpose of investing in two foreign investment companies so created and structured as to secure their shareholders a certain number of tax benefits. Incorporated in Panama, where their income was not taxable, the companies had as their objective investing mainly in Canada in debt securities not subject to the usual withholding tax and reinvesting the major portion of their profits, retaining only a relatively minimal portion for purposes of distribution in dividends to the shareholders.

The sums involved are clearly substantial. The capital gain realized by the appellants upon the resale of their shares in 1985 was $9.24 million. They had received some $600,000 in dividends over the eight years, but the interest on the sums they had borrowed to invest amounted to $6,000,000. As we know, it is this six million dollars claimed as a deduction by the appellants that the Minister refused — a refusal upheld first by the Tax Court of Canada, then by the Trial Division in the judgment that is the subject of this appeal.

I have no particular difficulty with my colleague’s detailed description of the facts, but I think two comments are in order in that regard.

I fail to see the point in stressing the waffling by officials in the Department of National Revenue as to how to stem the multiplication of these investment vehicles organized offshore or their efforts to bring about a legislative solution to some of the problems involved, or their hesitations and the discussions they may have had among themselves concerning the treatment the appellants’ particular case should be given. This may be an indication of the level of interest in and the complexity of the overall problem but it is certainly no reason to argue against the position ultimately adopted in this case by the Minister.

Nor do I see the point in stressing the fact that the organization of the two companies as investment vehicles was conceived and implemented without violating the Act in any way. That is self-evident, and adds nothing. It applies to every stratagem dreamed up by tax practitioners as a means of limiting their clients’ tax obligations, provided, of course, that such stratagems have some prospect of survival. Were it otherwise, the issue before the Court would not exist. Let me hasten to point out that I do not react negatively to a taxpayer’s efforts to find ways to lessen the burdens of taxation. I have no hesitation in accepting the Supreme Court’s instructions that it is not our duty, as judges, to in some way amend the Act or alter the legal effects of a transaction in order to avoid some adverse effect on taxation that apparently was not anticipated.

But while I have no real difficulty with my colleague’s presentation of the facts, his analysis of the trial court’s judgment differs somewhat from mine.

The trial judge refers not to any “primary purpose” but to a real purpose, a true purpose pursued by the appellants in investing in these two companies organized as they were, and he defines this purpose as being “to defer taxes through the accumulation of earnings and to have the profits subject to capital gains treatment on disposition of their shares”.

This is indicated by the judgment as a whole, and particularly by the very passages relied on by my colleague when he refers to the “primary” purpose. Here they are again:

[66] ...In this case, the plaintiffs’ purpose in investing $7.5M in Justinian, with its access to Mr. Meade’s expertise, was fully consistent with the company’s structure: to defer tax through the accumulation of earnings and to have the profits subject to capital gains treatment on disposition of their shares. For the $6.5M portion of their investment which was leveraged, the plaintiffs’ additional purpose was interest deductibility. They did not use the borrowed funds for the purpose of earning a dividend yield substantially less than their interest expense. In the words of Chief Justice Dickson in Bronfman (at page 54), the plaintiffs did not satisfy this Court that their “...bona fide purpose in using the funds was to earn income.”

[68] In this case, as in Mark Resources inc. v. The Queen (1993), 93 D.T.C. 1004 (C.T.C.) at 1012, the earning of dividend income cannot be said to be the real purpose of the use of the borrowed funds. Justinian’s dividend payments were “subservient and incidental steps to the real objective that lay behind the implementation” of its policy to accumulate and reinvest earnings which, upon disposition of the shares through redemption, would be taxed as capital gains.

[69] The recent decision of the Supreme Court of Canada in Hickman Motors Ltd. v. Canada, [1997] 2 S.C.R. 336, and the obiter dicta in Mark Resources Inc., supra, at 1013-15 do not find their application, in my view, to the facts of this case, and more particularly, to the true purpose of the plaintiffs’ investments in Justinian in the context of the object and spirit of the Income Tax Act as a whole.

[70] The application of these principles to this litigation is straightforward. On the evidence in this case, the borrowed funds were not used for the purpose of earning income within the meaning of sub-paragraph 20( 1 )(c)(i). The dividends were neither profit nor could they be the basis of a reasonable expectation of profit in 1977, when the plaintiffs’ interest cost was 10%, or at any time thereafter. As Mr. Ludmer succinctly stated, the plaintiffs did not borrow money to lose money. They made their money, however, upon the disposition of their shares. Their profits, which they expected and realized, are capital gains, not income. This is the very outcome foreseen in Justinian’s Explanatory Memorandum.

[Emphasis added. I

As I read his reasons, the judge bases his judgment on his finding as to the real purpose. What he says about the insignificance of the dividends and the impossibility of finding any purpose in their increase that could possibly serve as a motivation is developed only in order to support the key finding.

And I will say right away that in my view this finding — that the appellants’ true purpose in investing in the two companies as structured was to defer tax and transform the income into capital gains — is a finding of fact. Unless it can connect it with any patently erroneous assessment of the evidence, which is impossible in this case, in my opinion, this Court can only defer to this finding of fact. But I will return later on to this central point in my reasoning.

I was saying a moment ago that this issue of deduction of interest under subparagraph 20(1 )(c)(i) of the Act had been the subject of many major decisions, and a number of them are in fact cited by the trial judge in his reasons and by counsel in their factums. My colleague does likewise in the notes he has prepared.

These decisions have certainly helped to clarify the meaning of the provision and limit its scope. They have defined its purpose, identified the relevant factors, and indicated the appropriate approach to be adopted in verifying its applicability. But I do not think there is even one decision that pertains directly to the problem raised, as I see it, by the case now before us. And perhaps the best way in which to ask the question which we must answer is, first, to distinguish it from the issues addressed by these other cases.

The decision that is most often cited and is the most instructive is the one in Bronfman Trust v. Z?., [1] in which Dickson C.J. subjects subparagraph 20( 1 )(c)(i) of the Act to a lengthy analysis. But the issue in that case was whether the requisite condition under the provision was satisfied in the case of a loan by the Trust that had been used for a distribution of money to the beneficiary but, in the words of the Trust’s administrators, had been made for the purpose of avoiding the liquidation of income-generating assets. Replying in the negative to this question, the Supreme Court emphasized the principle that the intention had to be expressed in the actual use of the borrowed money and, accordingly, absent exceptional circumstances, a use for purposes that were ineligible under the Act — that is, not made “for the purpose of earning income from a business or property” — would not allow the deduction of the interest. A merely indirect intention would not normally suffice. The application of this principle was at issue in this Court’s judgment in 74712 Alberta Ltd. v. Minister of National Revenue^ [2] and the Tax Court’s judgment in Robitaille c. R.? [3] But the issue before us in the instant case is not one of that nature, since the use here directly implemented the intention and no dichotomy is apparent. The correlation between use and purpose is established.

Nor are we confronted with a case of multiple transactions linked to each other for some ultimate purpose, where the issue is whether this ultimate purpose should have such priority as to render inoperative, as strictly subordinate thereto, the particular purposes pertaining to each individual transaction. That was the problem raised in Mark Resources Inc. v. /?., [4] as in Canwest Broadcasting Ltd. v. /?.. [5] It is not the issue in the case at bar. The transaction here is as simple as can be.

And finally I would add, although it is not as obvious and I shall return to it, that the issue before us does not necessitate that we determine whether the word “income” in the provision is to refer to net income, as in section 9 of the Act, or gross income. In my view, it is unnecessary to choose between the reasoning of Linden J.A. in Tonn v. R. [6] and that of Bowman J. in Mark Resources J [7] supported by the remarks of Madam Justice L’ Heureux- Dubé in Hickman Motors Ltd. v. /?.. [8] Similarly, I do not concede that Moldowan v. R.,? [9] with its elaborations on the need for a taxpayer who says he has a source of income within the meaning of the Act to demonstrate that he has in mind a profit, or at least a reasonable expectation of profit, is applicable to the case at bar.

The problem posed by the facts in this case, as I see it, is simpler and more circumscribed then the one posed in all of these past cases. So what is it?

* * *

I said earlier that I had no difficulty aligning myself among the traditionalists in the interpretation and application of the Income Tax Act, in the sense that I dispute the thesis that it is the role of the courts to react against attempts at tax planning on the ground that the purpose being pursued ap- pears antisocial. The only relevant considerations are the legal effect of the transaction that was carried out and the strict application of the statutory provision in question, not the intention. But there is an “unless” attached to this proposition, and it is this: unless the Act in question makes intention a dominant consideration. And that is clearly the case with subparagraph 20(1 )(c)(i) of the Act.

The wording does not characterize the intention or the purpose referred to in either the French or English version. I, too, have some difficulty seeing how one can introduce characterizations and speak of primary or final or incidental intention, etc., but no one can be in any doubt that what Parliament has in mind is the actual or true, not feigned or merely claimed, intention. It is the factors peculiar to the search for this actual intention that most of the judgments cited earlier have sought to define. As I said, the idea that reliance could be placed on the statements of the interested party was quickly rejected. The intention had to be concretely expressed in the use of the funds and confirmed by the circumstances, and accordingly one could speak of “objective intention”, startling as the juxtaposition of these two words might be, in itself. And that, I submit with respect, is precisely the approach that the trial judge took in this case.

I said earlier, and I repeat, that to my way of thinking the finding reached by the judge at the conclusion of his analysis was one of fact that this Court should not reject unless it can detect some egregious error in the assessment of the evidence.

My colleague draws attention to the fact that the dividends in absolute figures were not insignificant and were comparable to many other investments, that the appellants, at the time of the investments, had in mind the payment of dividends, and even that, judging by their testimony, they would not have invested if it had been otherwise. With respect, I do not believe that these observations can be viewed as contradicting the trial judge’s conclusion. The fact that the investors thought the payment of dividends might allow them to claim a deduction on the interest does not alter the fact that this was not their true intention in investing in these foreign companies. It was perhaps a consideration, but not the true purpose they were pursuing. That purpose was precisely the one identified by the judge: essentially, to transform into non-taxable capital gains half of the taxable income that the investments made with their money might generate.

And the issue before us, then, is simply whether it is possible to say that a loan used for the purposes of acquiring shares in an investment company, so organized as to avoid or postpone the payment of taxes and particularly transform into capital gains at least half of the taxable income that its activities might yield, satisfies the statutory condition for deductibility of interest. In my view, this is a simple issue that allows, and I say this with respect for the contrary opinion, no answer other than a negative one. To say that the applicable test is limited to looking at whether income was paid out and taxed has the effect, it seems to me, of depriving the word “purpose” in the English version, and the corresponding expression “en vue de” in the French version, of any meaning and flies in the face of Parliament’s intention, as recognized from the outset by the Supreme Court in Bronfman. [10] ®

Appellants’ counsel would like to see in the reasons for judgment of Madam Justice McLachlin, and especially those of Madam Justice Claire L’Heureux-Dubé, in Hickman, supra^ [11] decisive support for their submission that, to trigger the application of subparagraph 20( 1 )(c)(i), it is enough to verify whether any income was produced. My colleague attaches some validity to this view, so I feel the need, with respect, to devote some effort to disputing its merit.

In Hickman the issue was whether a deduction for depreciation under subsection 20(1) and section 88 of the Act was possible in relation to a business that the appellant had carried on for only five days after acquiring it. Two conditions were required. One, drawn from the actual words of subsection 20(1), was that the business pertained to an already-existing source of income of the appellant. The other was that the business had been acquired for the purpose of producing income, so as to avoid the exclusion under subparagraph 1102(1) of the Income Tax Regulations. This exclusion of “property that was not acquired by the taxpayer for the purpose of gaining or producing income” is aimed, as McLachlin J. notes, at “ensuring that the asset for which the deduction is claimed is an asset associated with income production as distinguished from an asset acquired for a non-income producing purpose, such as pleasure or personal needs”. [12] In regard to the first condition, McLachlin J., writing on behalf of herself and two other members of the Court, accepted the position adopted by her colleague L’Heureux-Dubé J., who said it was met on the basis of the evidence. In regard to the second condition, however, McLachlin J. simply relied on subsection 1102(14) of the Regulations, under which property of a prescribed class acquired as a result of the winding-up of a Canadian corporation to which subsection 88(1) of the Act applies retains its class with the purchaser, who is deemed to have intended to hold it in that capacity. Since in this case it was depreciable property, she reasoned, it should, in the purchaser’s hands, remain depreciable property, that is, property used for the purpose of gaining or producing income, so long as the purchaser did not commence to use the property for some other purpose, and there was no evidence that this had happened.

In the opinion of L’Heureux-Dubé J., who wrote on her own behalf, the so-called “purpose of producing income” test, interpreted in light of Bolus- Revelas-Bolus Ltd. v. Minister of National Revenue,' [13] an earlier case in which the property acquired had not in fact produced any income, was superfluous where the property had, in fact, produced income, and accordingly paragraph 20(1)(a) should, in her opinion, be interpreted as contemplating “[income-producing] property [or, alternatively, property acquired for the purpose of producing income]”.^ [14] And it is in the context of this discussion that the sentence quoted by my colleague [15] is found.

In my opinion, the situation in Hickman is quite distinct. The expression “for the purpose of gaining or producing income” is used in a regulation that has a precise objective, ensuring that property that is not acquired in order to produce income but in order to be used otherwise is not used as a deduction for depreciation. L’Heureux-Dubé J.’s observation is understandable in the circumstances. But I think it is unacceptable to apply it as such to the interpretation of cases under the exceptionally liberal subparagraph 20( 1 )(c)(i), because, I repeat, this would render meaningless the key words used and flout Parliament’s intention when it used them.

Appellants’ counsel argued as well in indirect support of their submissions that a decision denying their clients the benefit of subparagraph 20( 1 )(<?)(i) might disrupt the entire securities market by jeopardizing the situation of all investors. I disagree. It is quite possible that an ordinary investor has a more specific purpose than that of increasing by whatever means the value of his investment, and it is also possible that he may or may not anticipate the receipt of dividend income, but in my opinion it will very seldom be the case that in choosing a particular investment his purpose is precisely to reduce as much as possible, and even refuse, so to speak, the income that the investment is likely to produce.

One last point before closing. At the end of his reasons, the trial judge quickly disposes of an alternative submission that the appellants had made, to the effect that if the only purpose of the transaction was to realize a capital gain, this would be an “adventure in the nature of trade” allowing the deduction of interest. I have nothing significant to add to what the judge says in rejecting this submission, especially because it was not argued extensively in this Court. Accordingly, I will only refer in this regard to the Supreme Court’s decision in /Irrigation Industries Ltd. v. Minister of National Revenue)^ [16] in which a similar problem was raised, and I will simply quote three paragraphs from the head note, referring to the reasons of Martland J., writing on behalf of the majority:

The transaction in question did not fall within either of the positive tests which the authorities have suggested should be applied in determining whether or not a particular transaction does or does not constitute an adventure in the nature of trade, Le.. (1) whether the person dealt with the property purchased by him in the same way as a dealer would ordinarily do, and (2) whether the nature and quantity of the subject-matter of the transaction may exclude the possibility that its sale was the realization of an investment or otherwise of a capital nature, or that it could have been disposed of otherwise than as a trade transaction. Minister of National Revenue v. Taylor, [1956] C.T.C. 189; The Commissioners of Inland Revenue v. Livingston (1926), 11 Tax Cas. 538; Leeming v. Jones. [1930] I K.B. 279, referred to.

The appellant’s operations in purchasing and selling the shares did not constitute the sort of trading which would be carried on ordinarily by those engaged in the business of trading in securities. What the appellant did was to acquire a capital interest in a new corporate business venture, in a manner which had the characteristics of the making of an investment, and subsequently to dispose, by sale, of that interest.

Although it might be contended that persons may make a business merely of the buying and selling of securities without being traders in securities in the ordi- nary sense, and that the transactions involved in that kind of business are similar, except in number, to that which occurred here, it had, however, been pointed out in Californian Copper Syndicate v. Harris (1904), 5 Tax Cas. 159, that, where the realization of securities is involved, the taxability of enhanced values depends on whether such realization was an act done in the carrying on of a business.

Those, then, are the reasons why I believe I must, with respect, dissociate myself from the opinion expressed by my colleague, being of the view, unlike him, that the impugned judgment below is well founded, at least in its conclusion. I would therefore dismiss the appeals with costs.

Desjardins J.A. (concurring):

As noted by my colleague Létourneau J.A., the respondent does not dispute the proposition that the tax planning that led to the creation of Justinian and Augustus corporations, and their operations, were perfectly lawful, that the transactions that took place were not artificial or a sham, that the dividends were actually paid out to the appellants and taxed by Revenue Canada, and that the appellants dealt with the companies at arm’s length.

That is not the point in issue.

Rather, the question is whether the appellants, in determining their income for the 1981 through 1985 taxation years inclusive, are permitted to deduct the interest costs arising from bank loans that enabled them to invest in the companies in question. Subparagraph 20(1)(c)(1) of the Income Tax Act^ [17] (“Act”) entitles the appellants to do so if the money they borrowed was used for the purpose of earning income from property (“utilisé en vue de tirer un revenu d’un bien”).

It would be helpful at this stage to reproduce subparagraph 20( 1 )(c)(i) of the Act:

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)

20. (1) Nonobstant les dispositions des alinéas (18(1)a), b) et h), lors du calcul du revenu tiré par un contribuable d’une entreprise ou d’un bien pour une année d’imposition, peuvent être déduites celles des sommes suivantes qui se rapportent entièrement à cette source de revenus ou la partie des sommes suivantes qui peut raisonnablement être considérée comme s’y rapportant:

c) une somme payée dans l’année ou payable pour l’année (suivant la méthode habituellement utilisée par le contribuable dans le calcul de son revenu), 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 (autre que l’argent emprunté et utilisé pour acquérir un bien dont le revenu serait exonéré d’impôt ou pour prendre une police d’assurance-vie) [...]

The words “for the purpose of” (“en vue de”) go to intent or purpose. As my colleague Létourneau J.A. has noted, the case law refers to the taxpayer’s real or true purpose [18] in using the borrowed money.

I agree with my colleague Létourneau J.A. that the respondent cannot succeed in her submission that in order for the essential condition of subparagraph 20(1)(c)(1) to be met and interest to be deductible, the investor’s dominant purpose must have been to derive income from the borrowed amounts. I share his view that the taxpayer need only have had a reasonable expectation of income at the moment the investment was made, [19] and that the borrowed money must have been used to acquire property for the purpose of deriving gross, not net, income. [20]

None of this leads me to conclude that the appellants are entitled to deduct the interest on their loans during the years in issue, however.

Rather, the evidence establishes beyond a shadow of a doubt that the real purpose the appellants had in mind when they borrowed the money was to acquire property (shares in Justinian and Augustus) that would produce a capital gain. The dividends they received, and on which they paid tax, were merely secondary and incidental to their loans and investment.

The intention is revealed by the documents that established the structures of the corporations in which the borrowed funds were invested.

The first document, dated September 4, 1976, and prepared by legal counsel, is entitled “Memorandum Respecting the Establishment of a Non- Resident Investment Organization for Canadian Investors.” [21] The purpose of the memorandum was as follows:

The purpose of the memorandum is to outline a proposed investment vehicle designed to combine attractive tax deferral and savings with personal, responsive, and individually structured investment programs.

The memorandum sets out the essential elements of a potentially tax-deferring corporate vehicle established in a tax haven and goes on to explain the tax consequences of activity that might be carried on by the Canadian taxpayers. It contains the following three paragraphs: [22]

26. Distributions from the non-resident corporation to the Canadian shareholders would give rise to taxable dividends which would not be eligible for the beneficial “gross-up and credit” mechanism provided by section s 81 and 121 of the Income Tax Act with respect to dividends from Canadian corporations. Therefore, substantial Canadian income tax would ultimately be payable on the investment income when received by dividend payments, although in the interim substantial earnings could be accumulated ON the deferred taxes.

27. The preferable manner of repatriating the earnings of the foreign investment corporation would be by a redemption of shares. In particular, the deemed dividend rules of section 84 rules of the Income Tax Act would not apply (such rules are applicably only to redemptions by a Canadian resident corporation) with the result that the accumulated investment income of the foreign corporation would be subject to Capital gain treatment pursuant to the provisions of subdivision c of Division b of Part I of the Income Tax Act and comparable provisions of the Taxation Act of Quebec, as applicable.

28. For example, $ 100,000 compounded at 10% after-tax at the end of ten years would have a value of approximately $250,000 whereas the same $100,000 compounded at an after-tax yield of 3% (in the case of direct investment by a Canadian in the highest tax bracket) would amount to perhaps no more than $150,000 after ten years. A return of investment income by way of redemption of shares (as opposed to dividend payment) would provide the basis to optimization of the overall tax savings. Applying these numbers, a Canadian income tax of approximately $40,000 to $50,000 would be incurred with respect to the cumulative interest income of $150,000 providing a net income return of at least $100,000 at the end of ten years as compared to the net income return of $50,000 in the case of the direct investment by the Canadian investor. Therefore, the result is a doubling of the investment income.

[Emphasis added.]

A second document, dated January 27, 1977, and entitled “Memorandum on the Formation and Operation of Offshore Fund”, [23] provided the basis for creation of the two corporations. The document contemplates the creation of a corporation under Panamanian law, with headquarters in the Bahamas or some other jurisdiction where no tax would be payable. The manager and most directors would only reside where they would not be taxed. The annual meetings would be held in locations that would not be reached by tax laws. [24] The investments would be limited to debt securities that would not be subject to withholding tax under Canadian or U.S. tax law. For greater safety, the certificates held by the corporations would be kept in the United States.

The next document served as a sort of prospectus for the two companies, which purported to be private corporations within the meaning of the various provincial securities statutes. It is entitled “Confidential Explanatory Memorandum” [25] and dated April 26, 1977. The document purports to be intended for no more than fifty sophisticated individual or institutional investors who do not need immediate liquidity for their investments. The investors would in fact be called upon to declare that they intended to purchase shares for the purpose of investment. Provision was made for two types of shares: Class A voting shares and Class B non-voting shares. The minimum investment was US$100 000, and additional subscriptions were available in blocks of US$50 000. To ensure provisions concerning foreign affiliates did not apply, no Class A shareholder was allowed to own more than 9.9% of the shares. [26] The investment policy was as follows. The corporate funds would be invested exclusively in fixed income securities, specifically debt securities. The objective was to ensure a reasonably stable and high rate of income. To this end, the fund managers sought securities that offered optimum chances of above-average rates of return and long-term capital growth. The securities would be disposed of in a manner that was free of tax consequences. The document concluded that if all the conditions were met, the interest earned and the capital gains realized on disposition would not be subject to Canadian tax.

The dividend policy set out in the April 26, 1977 document, was that the earnings would initially be accumulated for reinvestment. But the directors of the Fund could declare dividends if they felt it would be in the best interests of the Fund and its shareholders to do so. A preliminary document dated August 15, 1977, provided that the directors were to consider the tax situation of their shareholders before declaring a dividend. This clause was removed from the final document so that the Directors would not have to make such inquiries of the shareholders. However, in 1981, the dividend policy was amended to provide that if the corporation realized earnings, the shareholders could expect a declaration of dividends. In 1981, the policy was changed to provide as follows:

The Fund accumulates the major portion of its earnings for reinvestment. However, in the past, it has been the policy of the Board of Directors of the Fund to declare and pay a dividend to shareholders for years in which the Fund has earnings, and it is anticipated that the Board of Directors will continue to follow this policy. Payment of dividends will be made in Canadian dollars or any other currency selected by the Board of Directors of the Fund. [27]

A dividend of $1.00 per share was declared for each of the fiscal years in issue. The value of the shares increased from $100.85 in 1977 to $222.84 in 1984.

At the behest of Arnold Steinberg, the two private corporations were tailor-made to meet these objectives. Steinberg became a shareholder and the only Canadian director. He is not one of the appellants.

Irving Ludmer is the sole shareholder of the appellants Ludco Enterprises Ltd. He was President and chief operating officer of Steinberg Inc. until 1979. He managed the money of his three children, who are the other three appellants. Nowhere is it claimed that the appellants were unaware of the contents of the documents.

The appellants invested in corporations structured to accumulate capital gains. The investment was long-term, in a tax haven, and tied to what was initially a no-dividend policy (although dividends were received) with the possibility of a redemption of shares by the Fund. In 1984, the Income Tax Act was amended. It provided that certain types of income earned by nonresident investment funds were deemed to correspond to a prescribed annual amount, taxable as income in the taxpayer’s hands whether the taxpayer received it or not. [28] The appellants then repatriated their money in accordance with the advice their legal counsel gave them in the first document, “Memorandum Respecting the Establishment of a Non-Resident Investment Organization for Canadian Investors”, dated September 4, 1976:2? [29]

A return of investment income by way of redemption of shares (as opposed to dividend payment) would provide the basis to optimization of the overall tax savings.-™ [30]

The companies’ accumulated profits were thus converted into capital gains in the appellants’ hands.

There is nothing scandalous about the fact that the appellants were seeking to minimize their taxes in this way. They were certainly entitled to conduct their business in such a manner as to pay the least possible tax. But there is no doubt that they made this investment “for the purpose of” realizing a capital gain. Taken together, the corporate structure established in a tax haven in which the appellants invested, the investment policy (which consisted exclusively of fixed-income debt securities), and the redemption method, are clear indications that the real objective of the appellants was to make capital gains. Their activity was certainly lawful, but where such investments are made with borrowed money, the interest paid is not deductible.

It is true that the Justinian and Augustus shares produced dividends. The appellants received them and were taxed on them. But receiving dividends was not the real objective sought by their investments.

Even assuming, for the sake of argument, that my colleague Létourneau J.A. is correct [31] in stating that it is possible to infer from the decision of the Supreme Court of Canada in Hickman Motors Ltd. v. Æ. [32] that there is a presumption that a taxpayer who acquires property that produces any amount of income probably intended to derive income from that property, the documents alone — the “Memorandum Respecting the Establishment of a Non-Resident Investment Organization for Canadian Investors”, the “Memorandum on the Formation and Operation of Offshore Fund” and the “Confidential Explanatory Memorandum” — rebut this presumption in the case at bar.

This Court is not concerned with the Revenue Canada policy that my colleague Létourneau J.A. discusses at length. It would appear in the case at bar that Revenue Canada did not follow this policy. In any event, it does not change the Act in any way.

Although the trial judge erred in law on several points, his conclusion was supported by the evidence before him.

I would dismiss the appeal, with costs.

Létourneau J.A. (dissenting):

This is an appeal from a decision by a judge of the Federal Court — Trial Division, dated December 9, 1997. The appeal concerns the appellants’ right, under subparagraph 20(1)(c)(i) of the Income Tax Act [33] (Act), to deduct from their income the interest they paid on amounts borrowed to acquire shares in two offshore companies. In the case of the appellant Les Entreprises Ludco Ltée/Ludco Enterprises Ltd., the appeal also raises the issue of the validity of that deduction after May 12, 1983, when the appellant disposed of its assets in both offshore companies to the numbered company 2154-7203 Québec Inc. through a transfer under section 85 of the Act. Last, depending on the interpretation given to subparagraph 20(l)(c)(i), the Court may have to determine whether the interest expenses were incurred in respect of operations intended to unduly or artificially reduce the appellants’ income within the meaning of subsection 245(1) of the Act.

The interpretation of subparagraph 20( 1 )(c)(i) is thus at the heart of this matter, and I think it advisable to set out the terms of that provision here and now:

20. (1) Notwithstanding paragraphs 18( 1 )(«), (b) and (A), 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)...

20. (1) Nonobstant les dispositions des alinéas 18( 1 )<?), b) et h), lors du calcul du revenu tiré par un contribuable d’une entreprise ou d’un bien pour une année d’imposition, peuvent être déduites celles des sommes suivantes qui se rapportent entièrement à cette source de revenus ou la partie des sommes suivantes qui peut raisonnablement être considérée comme s’y rapportant:

c) une somme payée dans l’année ou payable pour l’année (suivant la méthode habituellement utilisée par le contribuable dans le calcul de son revenu), 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 (autre que l’argent emprunté et utilisé pour acquérir un bien dont le revenu serait exonéré d’impôt ou pour prendre une police d’assurance-vie) [...]

Facts and proceedings

The main facts giving rise to this matter are not in dispute and can be summarized as follows. The appellants are Canadian residents. They invested $7.5 million in the purchase of shares in offshore companies: Justinian Corporation S.A. (Justinian) and Augustus Corporation S.A. (Augustus). Both companies were incorporated in Panama under Panamanian law. They were created purely for tax purposes for the benefit of their shareholders. Their objective was to invest in debt securities in Canada and the United States. They operated from the Bahamas where their income was non-taxable. They were also non-taxable in Canada because their corporate structure was such that they were not subject to the provisions of the Act (sections 91 to 95) designed to prevent property income from being channelled into a tax haven or, if it was, from being exempt from Canadian tax.

The appellants acquired the shares through five different transactions between September 1977 and June 1979, and held them until cashing them in in 1985. In order to secure this share acquisition, the appellants borrowed $6.5 million, on which they had to pay $6 million in interest. Over this period, the shares generated an income of $600 000 for the appellants in the form of dividends. When the shares were sold in 1985, the appellants made a capital gain of $9.2 million. Then, in 1986 and 1987, the Minister of National Revenue (Minister) disallowed the deduction of the interest they had paid and claimed for taxation years 1981 to 1985, the Minister’s position being that the amount borrowed had not been used for the purpose of earning income from property as paragraph 20(1)(c) of the Act requires.

In addition, in the case of the appellant Ludco Enterprises Ltd., the Minister was of the view that for taxation years 1983 to 1985, it no longer had any source of income after May 11, 1983, in any event, since it had disposed of its source of income in 1983 by transferring the property to a company that was not a source of income.

The following table produced by the respondent, the amounts in which are not in dispute, shows the distribution of dividends received and interest paid each year by the appellants:

The evidence in the record shows that, although government policy was encouraging and promoting investment in Canada by offshore companies, Revenue Canada frowned on the investment that Canadian residents were making in Canada through offshore companies that paid no tax in Canada [34] . Justinian and Augustus corporations had been created for that purpose and allowed Canadian residents to do two things: postpone payment of taxes; and convert what would essentially have been taxable interest income as income from property into capital gains taxable at a lower tax rate (50%) and only when the property was sold. In addition, the potential for capital appreciation was greater and such appreciation did in fact occur because these companies operated in a tax haven where they paid no tax.

Justinian and Augustus corporations were thus conceived, and their operations planned, in light of Canadian income tax laws to allow their shareholders to minimize their payment of taxes owing to Revenue Canada as a result of their investments. I hasten to add that by the respondent’s own admission, the tax planning that led to the creation of these two companies, and their operations, were perfectly lawful, the transactions that took place were not a sham, the dividends were actually paid to the appellants and taxed by Revenue Canada and the appellants, being in no way involved in the management of these companies, dealt with them at arm’s length. Moreover, it is a well-known principle in Canadian tax law that a taxpayer may, by taking advantage of the provisions of the Act, arrange his or her affairs to pay — and with the sole aim of paying — the least amount of income tax [35] . In fact, the Revenue Canada Declaration of Taxpayer Rights, a copy of which is on the back cover of the General Income Tax and Benefit Guide provided to the taxpayer each year, states:

You are entitled to arrange your affairs to pay the least amount of tax the law allows.

In short, the clever plan proposed for Justinian and Augustus shareholders was the result of lawful legal planning. As a result, however clever and perhaps even irksome to some, that planning must not colour the legal analysis and interpretation of the right to deduct interest under subparagraph 20(l)(c)(i) of the Act.

The evidence in the record also shows Revenue Canada’s growing concern over the proliferation of these offshore companies made up of Canadian residents operating in the Canadian investment market as non-residents [36] Therefore, a law was passed in 1984 to discourage this type of arrangement by eliminating the tax benefits and advantages it generated [37] . Following this legislative amendment, the appellants disposed of their shares in these two companies by cashing them in.

The appellants challenged the notices of reassessment issued by the Minister in the Tax Court of Canada to no avail [38] . They unsuccessfully appealed that decision to the Trial Division of this Court, and the latter decision is now at issue.

Decision of the Trial Division

The substance of the decision of the Trial Division judge is found in the following passages from his reasons:

[66] ...In this case, the plaintiffs’ purpose in investing $7.5M in Justinian, with its access to Mr. Meade’s expertise, was fully consistent with the company’s structure: to defer taxes through the accumulation of earnings and to have the profits subject to capital gains treatment on disposition of their shares. For the $6.5M portion of their investment which was leveraged, the plaintiffs’ additional purpose was interest deductibility. They did not use the borrowed funds for the purpose of earning a dividend yield substantially less than their interest expense. In the words of Chief Justice Dickson in Bronfman (at page 54), the plaintiffs did not satisfy this Court that their “...bona fide purpose in using the funds was to earn income.”

[68] In this case, as in Mark Resources Inc. v. The Queen (1993), 93 D.T.C. 1004 (C.T.C.) at 1012, the earning of dividend income cannot be said to be the real purpose of the use of the borrowed funds. Justinian’s dividend payments were ‘‘subservient and incidental steps to the real objective that lay behind the implementation” of its policy to accumulate and reinvest earnings which, upon disposition of the shares through redemption, would be taxed as capital gains.

[70] The application of these principles to this litigation is straightforward. On the evidence in this case, the borrowed funds were not used for the purpose of earning income within the meaning of sub-paragraph 20(1)(c)(1). The dividends were neither profit nor could they be the basis of a reasonable expectation of profit in 1977, when the plaintiffs’ interest cost was 10%, or at any time thereafter. As Mr. Ludmer succinctly stated, the plaintiffs did not borrow money to lose

We are currently aware of nine offshore funds, two of which are being promoted by prominent brokerage houses.

money. They made their money, however, upon the disposition of their shares. Their profits, which they expected and realized, are capital gains, not income. This is the very outcome foreseen in Justinian’s Explanatory Memorandum.

Reading these passages leads me to conclude that the Trial Division judge dismissed the appellants’ arguments on two grounds. First, the real and primary purpose and use of the loans the appellants took out was not to earn income from property within the meaning of subparagraph 20( 1 )(c)(i), but rather to make a capital gain. Second, the dividends the appellants received were neither profit nor was there any reasonable expectation of profit because the interest cost greatly and inevitably exceeded the dividend amounts. I can only conclude from the judge’s second ground that he ascribed the meaning of “net income” or “profit” to the term “income” in subparagraph 20( 1 )(c)(i).

Legal analysis and interpretation of the right to deduct interest under subparagraph 20(1)(c)(i)

Interest paid on a loan is generally a capital expense that is not deductible from income from a taxpayer’s property or business unless that expense was incurred for the purpose of producing such income. The provisions of subparagraph 20( 1 )(c)(i) are thus an exception to the principle of non-de- ductibility, the objective being to allow a capital increase likely to generate taxable income [39] . In this case, it is not disputed that the interest was paid pursuant to a legal obligation and that the amounts were borrowed with the intention of acquiring capital in the form of shares in Justinian and Augustus corporations. It is also agreed that the amounts were used to purchase the shares, and therefore to acquire capital, directly. However, the respondent disputes the appellants’ argument that the capital was acquired “for the purpose of earning income” that is taxable under the Act. In other words, based on the courts’ interpretation of paragraph 20(1 )(c), the respondent submits that the borrowed money was not put to an eligible use [40] . I will analyse the two parts of this argument separately: first, the intention to earn income; second, the assertion that the concept of income refers to net income or profit.

I note that in English, subparagraph 20( 1 )(c)(i) uses the words “for the purpose of”, and that these words have been translated into French as “en vue de” [with a view to] rather than “dans le but de” [for the purpose of]. On this basis, counsel for the appellants argues that the French version of the Act is broader and thus more permissive. I do not believe there is any significant difference between the text of the two versions because, according to the Petit Robert [41] , “en vue de” means “dans l’intention de” [with the intention of| and is synonymous with the prepositional phrase “afin de” [in order to], which also indicates intention or purpose. I will therefore use the word “purpose” [but] to describe this essential condition of application of subparagraph 20(1 )(c)(i), that 1s, that the money is borrowed and used for the purpose of earning income from property.

a) Did the appellants acquire their shares for the purpose of earning income therefrom?

In subparagraph 20( 1 )(c)(i), Parliament described the kind of purpose sought by the acquisition of property, but did not indicate whether that purpose had to be exclusive, immediate, primary or dominant, or whether it could also be non-restrictive, ultimate, secondary or incidental. Based on Bronfman Trust v. R., supra, the courts have adopted and applied the real or true purpose concept in proceedings before them.

Thus, for example, in 747/2 Alberta Ltd. v. Minister of National Revenue^, [42] this Court disallowed the interest deduction because the appellant’s true purpose in borrowing and using the money was not to earn taxable income from property, but rather to enable one of its subsidiaries to meet its own financial obligations. In Mark Resources Inc. v. /?. [43] , to which the Trial Division judge referred, the Tax Court of Canada disallowed a deduction claimed by the appellant, on the ground that the real purpose in using the borrowed amounts was to import the losses incurred by one of its subsidiaries in the United States into Canada for deduction here.

The particular difficulty that arises in the case of an investment in the form of shares or debt securities lies in the fact that the investor is always pursuing a dual purpose. In Tonn v. J?. , our brother Mr. Justice Linden wrote:

A further matter worthy of mention is that real estate, like shares, may be purchased not only to create an income stream but with an eye to an eventual capital gain. Mr. Tonn testified that “real estate is a good long-term investment’’. One reason why real estate and securities alike present good investment possibilities is that they offer the possibility both of earning income and of obtaining capital gains in the future. Purchasers usually intend to profit from both the income and the longer-term capital aspects, and, if they do, they pay tax on both sources of profit. This matter was the subject of a comment by Martland J. in /rrigation Industries Limited v. The Minister of National Revenue where, speaking of the purchase of securities, he stated:

It is difficult to conceive of any case, in which securities are purchased, in which the purchaser does not have at least some intention of disposing of them if their value appreciates to the point where their sale appears to be financially desirable.

Recognizing this fact, the respondent submits that in a case of this kind, earning income from the borrowed amounts has to be the investor’s dominant purpose in order to meet the key condition of subparagraph 20( 1 )(c)(i) and allow the interest deduction. From that premise, counsel for the respondent concludes that an investor’s purpose does not meet the dominance test if the dividends paid are nominal or insignificant and therefore not likely to generate a profit as the subparagraph requires. He bases the latter requirement — the net income concept — on Mr. Justice Pigeon’s decision in Quebec (Deputy Minister of Revenue) v. Lipson^, in which it was held that by virtue of section 5 of the Provincial Income Tax Act* [46] (counterpart of section 9 of the federal Act), the phrase: to gain income, in section 15 of the provincial Act (counterpart of paragraph 18(1)(a) of the federal Act), means to yield a profit. I will come back to the scope and effect of that decision later.

I am not in favour of importing a dominance test into the interpretation of subparagraph 20(l)(c)(i). Not only is the respondent’s argument in this respect unsupported by the text of the Act, it also goes against both business reality and the objective sought by that provision of the Act. In addition, it leads to an undesirable tax uncertainty that might adversely and unjustifiably affect the business community and the Canadian economy. When a borrower seeks to achieve two objectives, that is to say to obtain dividends and make a capital gain, it is inappropriate, in my view, for the purpose of interpreting subparagraph 20(l)(c)(i), to accept one of these objectives, but reject the other on the basis that one more closely represents the borrower’s real or true purpose and, therefore, that the other is or must be unreal. To do that amounts, in practice, to ranking one objective above the other and thus introducing in the interpretation of the said subparagraph an unwarranted element of arbitrariness.

As I have already mentioned, subparagraph 20( 1 )(c)(i) does not stipulate that the borrowed money has to be used “mainly” for the purpose of earning income from property. The interest deduction is intended to encourage and allow for the acquisition of potentially income-generating capital. That is the conclusion to which the words “used for the purpose of earning income from property” lead us. It is therefore sufficient for the investor to have a reasonable expectation of income when investing borrowed money. It is not necessary for the investor to have an expectation of reasonable income.

Furthermore, a taxpayer who invests in shares or debt securities has no control over either income payment or the amount thereof. Due to the fluctuating and sometimes volatile business environment that affects companies and, I repeat, over which the investor has no control, a number of companies quite simply pay no dividends, suspend payment for relatively long periods of time or generate income that is clearly less than the amount of interest the taxpayer paid to earn that income from property.

To my mind, accepting the respondent’s dual argument — that the borrowed money has to be used mainly for the purpose of making a profit — would open the door to unfairness and capriciousness. In fact, it would enable Revenue Canada, 8 or 10 years later, with enviable insight but merely due to the materialization of often unforeseeable events over time, to cast a critical eye over an investor’s past to question the amount of the interest payments he or she has made, on the ground that they are higher than the income actually earned from the property. It would make it possible to require taxpayers, on a case-by-case basis long after the investments were made, to show that they originally had an expectation of reasonable income and not just a reasonable expectation of income. One does not have to be able to predict the future to imagine the potential proliferation of lawsuits and the legal and business uncertainty that would result from such an ap- proach, which for all practical purposes would discourage people from acquiring and accumulating capital through borrowing and even induce them to dispose of existing shares if they were unable to anticipate whether the income would match or exceed the interest cost of the borrowed money. In an internal Revenue Canada memo dated May 5, 1983, from the Director of the Tax Avoidance Division to the Legal Services Branch, the Director said clearly that the problem of interest deductibility also involved all Canadian investors who purchase shares:

As you are aware, this problem of interest deductibility is not restricted solely to offshore companies but may involve all Canadian investors who use borrowed funds to purchase shares of any corporation. ^

The respondent’s aim in proposing this interpretation is to ensure that the interest on borrowed money used to earn income is deductible only to the extent of that income. The respondent is attempting to have the courts restrict the scope of subparagraph 20(l)(c)(i), yet there has been no support in Parliament for legislative amendments to that effect.

In fact, in the 1981 budget, the Minister of Finance was planning to restrict interest deductibility in that manner for 1982 and the following years. However, Resolution 23, which was to carry out the Minister of Finance’s plans, was never passed . In draft legislation on the Tax Treatment of Interest Expense circulated in 1991, the Minister of Finance again proposed to restrict the deductible amount of the interest on borrowed amounts used to acquire shares where the shares bear a fixed dividend rate lower than the interest rate charged on the funds borrowed to acquire those shares [49] That proposal never became law.

Since January 12, 1983, even absent legislative provisions supporting its position, Revenue Canada was thinking of discouraging borrowing to invest in offshore companies by disallowing the deduction claimed for interest. In a letter to the Current Amendments Division at Revenue Canada, after acknowledging the complexity of the problem and referring to discussions with tax experts, the Director of Tax Policy and Legislation at the Department of Finance wrote:

They f that the courts would be particularly athetic and that some bloom would go off offshore mutual funds if the word were out that Revenue Canada intends to challenge the interest deductibility. While this would not solve the problem — the possibility of deferring tax and of converting income into capital gains would remain attractive — the threat of an interest disallowance would certainly discourage a number of investors. I therefore encourage you to pursue disallowance while we attempt to come to grips with the conversion-deferral aspects of the problem. [50]

(my underlining)

Subsequently, Revenue Canada announced publicly that in the case of investment in offshore companies, it was going to allow an interest deduction but only to the extent of the dividends received [51]

I have referred to this evidence in the record to emphasize the complexity of the problem surrounding the deduction of interest and, if in fact the scope of subparagraph 20( 1 )(c)(i) should be restricted, the danger of taking the place of Parliament and making policy changes judicially in this area.

Mr. Justice lacobucci put it so well in Canderel Ltd. v. R.°2: [52]

The law of income tax is sufficiently complicated without unhelpful judicial incursions into the realm of lawmaking. As a matter of policy, and out of respect for the proper role of the legislature, it is trite to say that the promulgation of new rules of tax law must be left to Parliament.

In short, it is not for us, as the respondent’s argument would have it, to rewrite subparagraph 20( 1 )(c)(i) to introduce a concept of degree, exclusivity or primacy in the taxpayer’s real or true purposes.

The respondent also submits, as I already mentioned, that the appellants’ purpose was not to earn income, since the income from the capital was nominal or insignificant — but insignificant relative to what? Obviously, if we compare it to the amount of interest paid ($600 000 in dividends for $6 million in interest), as the table the respondent produced shows, it is insignificant. However, that would be using a faulty basis of comparison because the interest is incurred to acquire capital that may generate income itself, and that is why the interest is deductible. In short, according to the respon- dent’s argument, subparagraph 20(1)(c)(1) requires as an extra — and implicit, it must be said, since it does not appear in the text of the provision — condition that the borrowed capital for which an interest deduction is claimed has to produce satisfactory income, otherwise it can be inferred that earning income was not the investor’s purpose. In my view, the response to this argument is twofold: (1) it is not supported by the text of the Act and judicial interpretation thereof, and (2) there is no basis for it in the evidence in the record.

In Hickman Motors Ltd. v. 7?. [53] , the issue was whether the assets for which a capital cost allowance was claimed under paragraph 20(1)(a) of the Act had been acquired for the purpose of producing income. Although the issue was not identical to the issue raised in this case, it nevertheless provides a significant analogy to the issue in this case, given that the issue here is whether the appellants’ assets were acquired for the purpose of earning income therefrom.

In the opinion of Madam Justice McLachlin, concurred in by La Forest and Major JJ., where assets are acquired for the purpose of producing income and, as a result, fall into the category of property eligible for a capital cost allowance, the fact that the income produced was small does not take the assets out of this category [54] Like Madam Justice L’Heureux-Dubé, who also wrote reasons, she held that the fact that the assets produced income established that those assets, which had been acquired to produce income, continued to be used for that purpose. For her part, Madam Justice L’Heureux-Dubé had this to say on the issue [55] :

Absent extraordinary circumstances, if a business owns an item of property that produces income, then presumably its purpose is indeed to produce income. The converse proposition would be absurd...

In my view, it is reasonable to infer from that decision that for the purposes of applying subparagraph 20(1 )(c)(i), absent an artificial or sham transaction or exceptional circumstances, there is a presumption that a taxpayer who purchases property that produces income, whatever the amount, probably intended to derive income from that property. That is an objective benchmark for the intention of the person who acquires that property. In my opinion, disregarding this obvious fact would introduce a judicial assessment test as a condition of application of subparagraph 20( 1 )(c)(i) of the Act, which has no legislative basis and would be open to undesirable subjectivity, that is, the court’s perception that the taxpayer took advantage of an improper tax benefit by deducting an overly high interest amount for income the court considers insufficient in relation thereto. We must take care not to import into the text of section 20, as a condition of eligibility for interest deduction, the tests of section 245 of the Act regarding tax avoidance, particularly because, as I have already mentioned, the amount of the interest deduction has to be assessed in relation to the amount borrowed, not the income earned.

The respondent’s argument that the income the appellants earned is nominal is not, to my mind, supported by the evidence when the comparison of that income is made with the business practices that were current at the time and the policies that the respondent was also applying at the time with respect to interest deduction on loans taken out to earn investment income. In that respect, the testimony of Mr. John Alexander Calderwood, Audit Director and later Director of the Tax Avoidance Division at Revenue Canada, is instructive.

When cross-examined on the guidance received for determining and evaluating the so-called “nominal” nature of dividend income, the witness had to admit that there were no criteria and that the determination was arbitrary. This is how he answered the question before the Tax Court of Canada judge [56] :

Q. Would you indicate to the Court, please, Sir, what guidelines or what criteria were given to the auditors or assessors to determine what was considered nominal dividends, Sir?

A. There was no guidance given to the field people on that subject.

Q. Would you indicate to the Court, Sir, what or how the field people were to define the concept of the nominal dividends”?

A. Well, we would expect them to use a normal meaning for such and such a term, but they still could not act on their own in any event and still had to go to Head Office, Tax Avoidance.

_ Alright. What was the percentage for a dividend to become nominal or to leave the nominal category, Sir? What way of return were you looking at as being nominal, at the time?

A. We didn’t have any criteria set, we would just take a small amount and made it nominal.

. Alright. Were there a comparisons made at the time. Sir, to your knowledge at the time? Were there any comparisons made against the going rates of return on dividends, on publicly-traded corporations in this country or elsewhere?

A. No. there was not.

Q, Were any comparisons made to the going rate or prime rate of interest being paid on rnoneys borrowed to invest inter alia in shares on publicly-traded corporations? :

A, No, there was not.

Q. Was there any correlation made or to be made with respect to the rate of interest to be paid to the bank and the rate of return on a share, by way of dividend to determine whether the return was nominal or not?

A, No, there as not.

Q. Is it also fair to say, Mr. Calderwood, that, at the time, and in nineteen eighty-four (1984), the rates, prime rate was much in excess of any rate or any return on dividends of publicly held corporations on any of the Canadian Stock Exchanges?

A. It likely was, yes.

Q. Is it fair to say, Sir, that it was much greater, the rate of interest one was paying to borrow money to buy into shares which were publicly-traded, was much greater than the return one would expect on the dividend on those shares, as a rule, at that time?

A. I couldn’t really say.

Q. You don’t know?

A. No.

(my underlining)

Furthermore, Revenue Canada’s policy at the time was to allow the interest deduction even if no dividend was paid to the investor, as appears from the testimony of Mr. Franco Tirabasso, Revenue Canada auditor [57] :

Q. All right. Would you indicate to the Court, sir, what rate or what criteria or standard did you apply to determine if, in those situations where you were dealing with nominal ... or let me backtrack.

Did you apply any comparison, did you make any comparison between the rate of return of a dividend and the money they were paying at the bank’?

A. No.

Q. Why not?

A. In most circumstances that I remember auditing, shareholders would borrow money to invest in their own ersona company which paid no dividends.

Q. And in those contexts, sir, would Revenue Canada allow the expense?

A. Yes, it would.

Q. Even though there was no dividend being paid?

A. We have a policy on that.

Q. And what was that policy, sir?

A. It’s an interpretation bulletin, and don’t ask me to go and...

Q. In general terms, sir, what was the policy at the time?

A. If it’s incurred to earn income, we will allow it.

Q. All right. And in this context you have just described, of an individual borrowing money from the bank to invest in his own corporation, would Revenue Canada allow the interest expense?

A. In most circumstances, they would.

Q. Even though there were no dividends being paid?

A. Yes.

Q. That was the policy at the time of your reassessment, sir?

A. Yes.

Q. All right. And did you also encounter cases where investors had borrowed money to buy into publicly-traded corporations, sir, or buy shares of publicly- traded corporations?

A. Yes, there are.

Q. And did you also apply the same rule as to whether or not a determination would be made about the existence of a nominal dividend or not?

A. The rule was not the existence of a nominal dividend, it was the fact that the investment produces income.

Q. I see. And it was enough for the share to yield a dividend?

A. Basically speaking, that would be.

Q. All right. And is there a percentage over which the expense was allowable and under which the expense was not allowable?

A. No, there is no policy.

Q. So do I take it then, sir, it is left to the assessor’s own determination whether it would be proper and appropriate in the circumstances?

A. With regards to?

Q. Deductibility of interest to buy into shares.

A. Buy into shares... the law is specific: it has to earn income following the law, it’s not up to the...

Q. I’m talking about policy, sir.

A. The policy. I think it’s written in the IT bulletin.

Q. Okay. Would you go to exhibit A-203, sir. You’re familiar with the policy, are you, Mr. Tirabasso?

A. Yes.

Q. You’re familiar (with) their outlines?

A. Yes, I am.

Q. And you’re familiar with question and answer number one (1), sir?

A. The question number one (1):

Can a taxpayer claim as a deduction interest paid to purchase shares nat are precluded from paying taxable dividends’?

and the answer is yes.

Q. Is your understanding of “precluded”, sir, meaning that the shares would not pay any dividends?

A. That’s right, that’s what it means.

Q. Isn’t my understanding then, sir, that according to this document Revenue’s policy was to allow interest expense, even for shares for which there would be no dividend being paid or possibly paid, or potentially paid?

A. As of this date, it’s dated February twenty-ninth (29th) nineteen seventy-six (1976)...

Q. All right.

A. ...this seems to be the answer.

Can a taxpayer deduct interest in respect of funds used to purchase speculative stock?

and the...

Q. You notice that question number one (1) has now disappeared as of eighty- four (84).

A. Yes.

O. So this policy was in force from nineteen seventy-six (1270) up to and including nineteen ighty-fou (1984), or the date ndicated i this document.

A. Yes.

Q. Do I take it then, sir, that Revenue Canada's policy at the time was to allow interest in shares which were precluded from paying any dividend to allow the interest expense on money borrowed to buy those shares? According to those documents, Sir.

A. Well, according to this document, 1 must say yes.

Q. Thank you.

(my underlining)

Why, then, disallow the deduction the appellants claimed? There is an eloquent answer to this question in the testimony of Mr. Tirabasso, the Revenue Canada auditor. According to him, the appellants’ investments were no different from investments in a company such as Bell Canada, except for the fact that Justinian and Augustus corporations were offshore companies [58] :

©. What s the difference here, sir?

A. The difference in this situation is the offshore element, I would assume.

Q. And to your knowledge, sir, that’s the only difference?

A. From what you've told me, keeping in mind the amount of dividends, 1 woulc pare this to a Bell anada kind of thing.

Q. And what would be the result if this were a Bell Canada kind of thing, sir?

A. Well, the difference is that if you invest in Bell Canada dividends are paid; they're not accumulated, and I think here they were accumulated — there is no...

I'm sorry, there is really no difference.

O, There is really no difference.

The only thing which is of any significance is the fact that these corporations were offshore. Is that your testimony, Mr. Tirabasso?

A. That's one of the elements. I can't see any other ones right now.

0, There are no other ones. Is that not fair. sir?

A. There is also maybe a question of control of the offshore funds which I would look into.

Q. Were there any other elements, sir?

A. That would be it.

OY. So the fa at the corporations were offshore is the only significant difference between that and a situation where an investor would buy into Bell Canada shares?

A. Yes.

Q. And would the same apply for all three (3) children and the company, sir, for all taxation years in issue?

A. Yes.

Q. And then do I take it, sir, that in those circumstances — if these were Bell Canada shares — Revenue Canada would have allowed my clients to pay the interest expense in full?

A. Again, as you stated before, if we invest in shares similar to Bell Canada, we would have allowed the interest expense.

Q. Even though there would have been a low yield?

A. Normally most public companies have a low yield.

Q. That’s not my question to you, sir. Even if there were a low yield...

A. Yes.

Q. ... Revenue Canada would allow the interest expense?

A. Yes.

J. nd is it not fair to say, sir, having regard to the policy that we have seen in > hotline questions, ha Revenue Canada would allow the interest expense even if there were no dividends?

A. According to the hotline, there was a specific question said no dividends, that’s correct.

Q. So that the appellants or the taxpayers here would be allowed to claim the full interest expense?

A^Y^s,

(my underlining)

It appears to me that the respondent’s decision to disallow the appellants the interest deduction claimed was based neither on the legislative provisions applicable in the case at bar nor on the policies followed with respect to other investors hoping to earn investment income from their acquired capital. It seems to me to quite simply have been dictated by the fact that the appellants had invested in offshore companies that allowed them to minimize the taxes they would have to pay. The following words of Iacobucci J. in ntosko v. Minister of National Revenue^ [59] are in my view highly relevant:

This transaction was obviously not a sham. The terms of the section were met in a manner that was not artificial. Where the words of the section are not ambiguous, it is not for this Court to find that the appellants should be disentitled to a deduction because they do not deserve a “windfall”, as the respondent contends.

Also, in Tennant v. /?.. [60] , the Supreme Court held that “s. 20( 1 )(c)(i) is not ambiguous”. This said, I nevertheless still have to consider the second aspect of the respondent’s argument — that the term “income” in subparagraph 20(l)(c)(i) refers to the concept of net income — which, according to the respondent, would justify disallowing the interest deduction or restricting it to the amount of income earned.

b) Does the concept of income under subparagraph 20(l)(c)(i) refer to net income or profit?

It is true that in Lipson, supra, Pigeon J. held that the word “income” meant net income. However, he reached that conclusion because he regarded the definition of the word “income” in subsection 9(1) of the Act, which determines the income from a taxpayer’s property or business for a taxation year, as being applicable to the entire Act. The Court in Interprovincial Pipe Line Co. v. Minister of National Revenue^ [61] unequivocally

dismissed that interpretation, being of the view that it was inappropriate to apply section [62] so broadly, since it expressly states that its content is subject to the other provisions of Part I, which includes subparagraph 20( 1 )(c)(i). In addition, Mr. Justice Locke recognized that the word income is used rather freely in the Act, at times to mean gross income, and at other times to mean net income or profit.

Lipson makes no mention of the Court’s earlier decision in Interprovincial Pipe Line Co. and that case does not seem to have been brought to Pigeon J.’s attention. In Mark Resources Inc. v. Rf\ [63] Judge Bowman of the Tax Court of Canada conducted a convincing analysis of these cases and of the respondent’s argument that the word “income” in subparagraph 20( 1 )(c)(i) necessarily meant “profit” because of this term’s definition in section 9 of the Act. Rightly, in my humble view, he dismissed that argument at page 1015 in these terms:

Accordingly I am unable to accept the interpretation of section 9 advanced by counsel for the respondent. To reject the appellant’s claim on this basis would mean that if the interests earned on the term deposits, and therefore the dividends, were slightly more than the interest paid on the bank loan, the entire interest paid would be deductible, whereas if the return were fractionally less, nothing would be deductible. To base the disposition of this case on such a technicality, without considering the overriding ultimate purpose, is unrealistic.... Moreover the interpretation contended for by the respondent in my view attributes to section 9 an effect that ignores its purpose. Its purpose is not to define income. Rather it emphasizes that in the computation of income one must apply, subject to the Act, “ordinary principles of commercial accounting so far as applicable and in conformity with the rules of the Income Tax Act”. Interest on money that is borrowed to invest in common shares, or property, or a business or corporation is deductible because it is laid out to earn amounts that must be included in the computation of income. Amounts of income such as dividends which must be included in income under aragraph (1) and k) do not as to 1‘ income merely because they are exceeded by the cost of their production.

(my underlining)

The argument the respondent submits to us today was not raised directly in Tennant v. /?. [64] , but to my mind the Supreme Court of Canada implicitly dismissed it.

In Tennant, the appellant had bought a million common shares in 1981 for $1 each. To acquire this capital, he had taken out a loan of $1 million and he claimed the interest deduction under subparagraph 20(1)(c)(i). In 1985, he disposed of his shares and received in exchange 1 000 class B shares worth $1 in another company. I note the contradictory position Revenue Canada took with regard to the present appellants for almost the same taxation years.) For 1981 to 1984, Revenue Canada allowed the deduction of interest expenses Mr. Tennant submitted even though they greatly exceeded the income earned from capital. The facts of that case do not indicate the amount of the investment income earned, but it is reasonable to think that if income was earned from that investment, it must have been extremely small because the value of the shares was plummeting. In fact, whereas the shares were worth $1 million when they were purchased, they were worth only $1 000 four years later.

The Minister issued notices of reassessment for 1985 and 1986 following the purchase of replacement shares in the other company, arguing that the interest Mr. Tennant paid was deductible only to the extent of the interest that would have been paid if the loan had been equal to the cost of the shares acquired in the new company, that is, $1 000. In short, the Minister’s argument was that the interest was deductible only to the extent of the value of the replacement shares.

The Supreme Court held that the amount of the interest deduction was to be calculated on the basis of the amount of the original loan, not the value of the replacement shares. In my view, it follows just as clearly from this conclusion that the amount of the interest deduction is not based on, nor can it be calculated on the basis of, the amount of the income earned from the investment, much less a concept of net revenue or profit. That is because, as the Court says, the purpose of the provision allowing the interest deduction is to encourage the accumulation of capital which would produce taxable income [65] . Moreover, in Minister of National Revenue v. M.P. Drilling Ltd [66] 66, this Court repeated the principle, upheld by the Supreme Court of Canada [67] , that an expense is deductible provided it was incurred for the purpose of producing or earning income even if no income, much less profit, was in fact generated.

It is also interesting to note that in Hickman Motors Ltd. v. /?. [68] to which I have already referred, in the context of paragraph 20(1)(a) of the Act, Madam Justice L’Heureux-Dubé was also of the view that the word income could have two meanings, either gross income or net income (profit). Hav- ing said that, she hastened to make a statement which in my view is unquestionable:

While an item of property may produce revenue, it does not necessarily produce profit by itself, and it would be absurd to demand that each individual item of property actually yield “net income” (profit) in and of itself.

Therefore, to the extent that the purpose in borrowing, and the subsequent use of the borrowed amount, was to acquire or increase capital for the purpose of earning gross income, it appears to me that the essential condition of subparagraph 20(l)(c)(i) has been met. I am aware that this Court mentioned in Tonn v. R.°? [69] which involved income from a business, that the reference to the word income in section 20 was to read as a reference to profit. To my mind, that was obiter in relation to income from property such as investment income, which as we have been able to see, presents particular and specific issues.

Does subsection 245( 1) of the Act apply to the appellants because they may have incurred expenses in an operation that unduly or artificially reduced their income?

The respondent argues that the interest deductions the appellants claimed for their investments in Justinian and Augustus artificially reduced their income. At the time, the applicable provision read:

S. 245. (1) In computing income for the purposes of this Act, no deduction may be made in respect of a disbursement or expense made or incurred in respect of a transaction or operation that, if allowed, would unduly or artificially reduce the income.

Art. 245. (1) Dans le calcul du revenu aux fins de la présente loi, aucune déduction ne peut être faite à l’égard d’un débours fait ou d’une dépense faite ou engagée, relativement à une affaire ou opération qui, si elle était permise, réduirait indûment ou de façon factice le revenu.

In my view, the respondent’s argument is unsound. As this Court mentioned in Fording Coal Ltd. v. R., the undue or artificial nature of the reduction of income is what has to be examined, not the artificiality of the transaction with which the expense is associated [70] . In this regard, incidentally, there was nothing artificial about the transaction as such, and the parties agree on that.

According to the case law, there are three factors involved in the application of subsection 245( 1 ) [71] , and I am of the view that the deduction the appellants claimed comes within the parameters of those three factors.

First, the interest deduction is in keeping with the object and spirit of subparagraph 20(1 )(c)(i), which as I have already mentioned, relates to the acquisition of capital with a view to earning income therefrom.

Second, the loan the appellants took out is in accordance with normal business practice relating to the acquisition of shares or debt securities. In fact, it often happens that the purchase of these assets by taxpayers is financed by bank loans and the assets given as security. For example, every year at this time, one need only observe the frenzy surrounding investment in registered retirement savings plans and the advertising about the financing available for that purpose. This is an incentive Parliament intended to provide.

Third, the loan the appellants took out had a bona fide business purpose. In fact, the borrowed amounts were used to purchase shares in Justinian and Augustus corporations. These companies generated profits and, as is often the case in such matters, they in part distributed those profits in the form of dividends to their shareholders and in part capitalized those profits. The evidence shows that the dividends the appellants received were within the range of dividend amounts paid by Canadian companies listed on the Toronto Stock Exchange. (I note that a number of companies pay dividends of less than 1% and that well-established companies at the time were not paying or for a time did not pay any dividends. For example, the evidence shows that Can-Am Manac has not paid any dividends since 1991 and that MacKenzie Financial Corporation paid its first dividends after 18 years in operation, which Cascade has never done since being created over 30 years ago [72] , despite having sales of $2.27 billion.)

In addition, a table the respondent provided shows that for the years in question, an investor derived, with respect to the taxation of his or her in- come, no tax benefit from the fact that the borrowed amounts had been invested in offshore companies instead of Canadian companies [73] ^:

Dividend Gross-Up & Tax Credit (Individuals)

Dividend Deduction - Part 1 (Corporations)

Basis of Examples

• Incremental income of $1,000

• Income is interest income (investment income)

• Income is not subject to withholding tax

° CCPC: Canadian Controlled Private Corporation

¢ NR Corporation not resident in Canada not subject to income tax in any jurisdiction

Facts

• Individual tax rates (Federal) 47% (max) ITA 117(5)

• Dividend gross-up: A of the dividend paid: subsection 82(1) of the Income Tax Act

• Dividend Tax Credit: A of gross-up: section 121

• Dividend Refund: lesser of RDTH and ’A dividend paid

¢ RDTH Refundable Portion of Part I Tax plus Part IV Tax payable minus dividend refunds of previous years

• Refundable Portion of Part I Tax: 25% of Investment Income (simplified)

• Part IV Tax: *A of Taxable Dividends received from Taxable Canadian corporations

Assumptions

• Corporate Tax Rate: 50% Federal + Provincial combined

° Individual Tax Rates (Provincial) 30% of Federal Tax

Sections 82 - Dividend Gross-Up and Sections 121 Dividend Tax Credit

Individuals

Income from a:	CCPC	NR
Income	1,000	1,000
Less

Income from a:	CCPC		NR
Tax Payable @ 50%		SOO
Net Income after Tax		500	I OOO
Plus
Dividend Refund		250
Refundable Part I (25% of income)
Available for Dividend		750	1,000
		- ,
Dividend Received by Individual		750	1,000
Gross-up (’A of the dividend)		250
Section 82 of the Income Tax Act
Taxable Income	1,000		1,000
	—
			— —■ ■ -
Federal Tax @ 47%		470	470
Less
Dividend Tax Credit ( A x Gross-up)		200
Federal Tax Payable		270	470
Plus
Provincial Tax Payable 30% of Fed.		8 I	141
Total Tax Payable		351	611
After Tax Income
Dividend Received		750	1,000
Less
Tax Payable		35]	611
	—
After Tax Income		399	389
Section 112-Dividend Deduction
Ludco
Income from a:	CCPC		NR
Income	1,000		1,000
Less
Tax Payable @ 50%		500
Net Income after Tax		500	1,000
Plus
Dividend Refund		250
Refundable Part I (25% of Income)
Available for Payment of Dividend		750	1,000
	—	■■
			■ », — — ■ » ■■
Dividend Received by Ludco		750	1,000

Income from a:	CCPC	NR
Tax Payable
Part I		500
Part IV	250
	—
		—
Net Income After Tax	500	500
Plus
Dividend Refund
Refundable Part I (25% of Income)		250
Part IV	250
	—
		■ '
Available for Payment of Dividend	750	750

In short, neither the investment in offshore companies nor the interest expense the appellants incurred unduly or artificially reduced their income. The fact that by investing in offshore companies, the appellants may have been fully entitled to postpone payment of their taxes and even save tax under the Act in the form of a capital gain does not make a lawful business objective unlawful [74] . These remarks by Lord Halsbury L.C. in Bradford (Mayor of) v. Pickles^ [75] sum up the reason well:

If it was a lawful act, however ill the motive might be, he had a right to do it. If it was an unlawful act, however good his motive might be, he would have no right to do it.

Did the appellant Ludco Enterprises Ltd. lose the benefit of the interest deduction by disposing of its source of income in 1983?

It will be recalled that on May 11, 1983, the appellant Ludco Enterprises Ltd. (Ludco) disposed of its source of income by transferring all the property, worth $12 685 000, it owned in the offshore companies Justinian and Augustus into a numbered company in Quebec.

In fact, in return for this transfer, the appellant Ludco obtained preferred dividend-bearing shares in the new company, worth $4 700 000. It also received $7 985 000 worth of promissory notes, only $605 000 of which generated interest income, however. They were subsequently converted into preferred dividend-bearing shares. At the time of the transfer, the appellant Ludco’s debt to the Bank amounted to $4 800 000, and the new incomegenerating assets totalled $5.3 million. The Supreme Court of Canada decision in Tennant v. /?. [76] makes it clear that an interest expense remains deductible if the income-generating property acquired with borrowed money is replaced by other property that also produces income, provided the replacement property thus acquired was acquired with the proceeds of disposition of the original property. The entire amount of the interest will be deductible if the acquisition of the replacement property can be traced to the entire amount of the loan. The deduction will be partial and proportionate if it can be traced to only a portion of the loan [77] .

Applying these principles identified by the Supreme Court of Canada to the facts of the instant case, one conclusion alone emerges: the acquisition of the taxable-income-producing replacement property — a $5.3 million asset — can be traced to the entire amount of the balance of the loan at the time of the transfer, that is, $4.8 million. In other words, the value of the taxable-income-generating assets acquired to replace the original assets was higher than the amount of the debt resulting from the loan. I am therefore of the view that the appellant Ludco did not lose the benefit of the interest deduction when it thus replaced its original source of income with another source that also generated taxable income.

I cannot end these reasons without adding the following. In my opinion, it is fundamentally unfair to disallow a particular taxpayer’s interest deduction on the basis of a purely arbitrary criterion when the same criterion is not applied to the other taxpayers, in the hope that the courts will be sympathetic to that approach by supporting it.

Furthermore, it is incorrect to suggest that the appellants were enriched at public expense. First of all, Revenue Canada taxed their dividends of $600 000 and their capital gains of $9.2 million without allowing them any interest expense deduction for the period in question.

Second, it is not the appellants’ fault that only 50% of the capital gain was taxable at the time.

Third, although it may at first appear that the appellants will make a profit at public expense if they are to be allowed to deduct the interest paid, it must not be forgotten that in addition to the income and substantial capital gains they reported and on which they were taxed, they also generated income of $6 million for the lending banks, which is taxable in the banks’ hands.

The bottom line is that although Revenue Canada may not have collected as much tax as it would have hoped, the public did not necessarily lose because the appellants’ investment through the acquisition of borrowed capital generated aggregate taxable income of $6.6 million with a loan of $6.5 million and a taxed capital gain of $9.2 million.

Conclusion

For all these reasons, I would allow the appeals and set aside the Trial Division decision dated December 9, 1997, and the assessments issued regarding the appellants for the 1981 to 1985 taxation years. I would allow the appellants a single set of costs before this Court and the Trial Division, plus expert costs.

Appeals dismissed.