Bowater Canadian Ltd. v. The Queen, 87 DTC 5287, [1987] 2 CTC 47 (FCA)

Urie, J.:—This is an appeal from the judgment of the Trial Division dismissing the appellant's appeal from reassessments made by the Minister of National Revenue on June 2, 1981 whereby, in the computation of the appellant's taxable income, he disallowed the deduction of interest in the sums of $75,898 for the 1977 taxation year, $254,629 for 1978 and $238,604 for 1979 and treated the sums of $75,898 for 1977, $127,314 for 1978 and $119,302 for 1979 as allowable capital losses.

The Facts:

Only one witness was called at trial by the appellant. The respondent adduced no oral evidence. There was filed, however, a partial agreed statement of facts, the salient portions of which I will summarize hereunder in some detail since they are of considerable importance in understanding respective submissions of counsel for the parties.

The appellant is a wholly-owned subsidiary of Bowater Corporation Ltd. which is a United Kingdom company founded in the 19th century and is engaged principally in the pulp and paper business. In 1938 it acquired the shares of Bowater Newfoundland Pulp and Paper Mills Ltd. which was in the business of the manufacture of pulp and paper. Most of its business is carried on in the United States. In 1952 the appellant, which at that time was known as the Bowater Corporation of North America Limited, acquired Bowater Newfoundland Pulp and Paper Mills Ltd. from Bowater Corporation Ltd. Subsequently it acquired a number of other subsidiaries including in 1965 an approximate 50 per cent interest in Bulkley Valley Pulp & Timber Limited. According to the appellant, its business in the relevant taxation years was and continues to be the provision of financial, administrative and technical services to companies in which it holds a substantial interest. The respondent, on the other hand, views the appellant’s business in the relevant years as that of a holding company rendering technical and administrative services to its subsidiaries and related companies. The appellant says that it negotiates on behalf of various subsidiaries with various banking institutions to secure the bank financing for their on-going needs. It assists in the management of the cash flow within the corporate group. This sometimes involves borrowing funds from one subsidiary and lending those funds to another. From time to time it would also borrow money from banks and lend funds so obtained to one or more of its subsidiaries at a profit. It also provides, where necessary, guarantees of the indebtedness of such companies to financial institutions. No fees are charged for the provision of such guarantees. In the field of technical services it assists in the hiring of appropriate personnel to engineer or manage projects and participates in the funding of pension plans for all of the subsidiaries. All administrative expenses incurred in those activities are charged back to the subsidiaries. The appellant expects to earn income in the form of interest and dividends from the companies in which it holds shares and whose affairs it administers. Large amounts of income earned from those sources in its 1969 to 1980 taxation years were disclosed in the evidence.

The acquisition of Bulkley Valley Pulp & Timber Limited (“Bulkley Valley”) in 1965 was made jointly, in equal proportions by means of subscriptions for treasury stock, with Bathurst Paper Limited, a predecessor corporation of Consolidated-Bathurst Limited (both hereafter referred to as "Bathurst"). The joint purchasers agreed to provide financial, technical and other assistance to Bulkley Valley under the terms of an agreement with the Province of British Columbia whereby Bulkley Valley was to be granted cutting rights for pulp wood in the Prince Rupert Forest district on the understanding that it would build a pulp mill to service the area. Bulkley Valley's performance bond, posted with the Province of British Columbia as part of the agreement, was guaranteed by the appellant and Bathurst. They also agreed, inter alia, to certain other obligations in support of Bulkley Valley in the development of its business.

Thereafter, Bulkley Valley proceeded to develop and operate a pulp-wood harvesting area in the course of which it built a town site, roads and a large sawmill. The following financial assistance was provided to Bulkley Valley by the appellant and Bathurst up to May 1, 1972:

(a) each acquired 663,510 common shares of Bulkley Valley at a cost to each of them of $7,938,234 representing in each case almost 50 per cent of the issued share capital;

(b) each acquired 10 per cent convertible notes of Bulkley Valley at a cost to each of them of $1,886,400;

(c) each acquired subordinate debentures of Bulkley Valley at a cost to each of them of $9,750,000.

To complete the sawmill development and to provide additional working capital the appellant and Bathurst each guaranteed one-half of bank loans made to Bulkley Valley under a bank loan agreement dated April 18, 1969 and amended on October 6, 1970, to a maximum guarantee of $10 million each. The appellant charged no fee to Bulkley Valley for this guarantee.

There was also an agreement between the appellant and Bathurst that they would, on demand, purchase additional debentures of Bulkley Valley in the sum of $6.75 million in respect of a loan given by a banking consortium consisting of the Bank of Montreal, Royal Bank of Canada and the Mercantile Bank of Canada.

Due to design problems and excessive costs of the sawmill project, the joint owners of Bulkley Valley decided in 1971 that the operation would either be closed down or sold. The appellant's witness, Mr. Robbins, testified that an important factor influencing the appellant's decision to dispose of Bulkley Valley was that it had become a financial drain on the rest of the appellant's operations.

In 1972 Northwood Pulp Limited ("Northwood"), a subsidiary of Noranda Mines Limited, agreed to purchase the shares of Bulkley Valley from the joint owners, the appellant and Bathurst, in order to consolidate the Bulkley Valley operations with its own operations in the region. The financial arrangements for the company were restructured pursuant to an agreement dated May 1, 1972. Pursuant thereto:

(a) Northwood acquired all of the common shares of Bulkley Valley at a price of $.05 per share subject to the Upward Price Adjustments Agreement also dated May 1, 1972 which provided for an increase in the purchase price in the event that Bulkley Valley generated excess cash profit as defined during the period February 1,1972 to December 31, 1981. No such profit was earned during the period;

(b) the appellant and Bathurst each agreed to sell to Northwood the subordinated debentures which each owned in Bulkley Valley for a gross sale price of $5;

(c) The appellant and Bathurst each agreed to sell to Northwood on January 1, 1982, the 10 per cent convertible notes which each owned in Bulkley Valley for a gross sale price of $5;

(c) The appellant and Bathurst each agreed to sell to Northwood on January 1, 1982, the 10 per cent convertible notes which each owned in Bulkley Valley for a gross sale price of $5;

(d) Northwood agreed to make a new loan to Bulkley Valley to enable it to reduce its bank loans to $11,905,000;

(e) The remaining Bulkley Valley bank loans, which were still guaranteed as to one-half each by the appellant and Bathurst, were refinanced out of the proceeds of Series "B" Notes issued by Bulkley Valley bearing interest at the rate of one and one-half per cent above prime, to the Bank of Montreal, Royal Bank of Canada and the Mercantile Bank of Canada.

In recognition of their obligations under the original bank guarantees the appellant and Bathurst each agreed with the banks to gurantee and to pay one-half of the amounts owing, both principal and interest, in respect of the Series “B” Notes. The banks agreed to assign these notes to the appellant and Bathurst as and when they were paid. The appellant received no fee from Bulkley Valley for entering into those agreements.

Bulkley Valley did not make any payments under the Series “B” Notes. All payments were made in equal proportions to the banks by the appellant and Bathurst. By October 4, 1977 each had paid directly to the banks in respect of the Series “B” Notes, the sums of $2.76 million plus interest. As a result, each had acquired Series "B" Notes in that amount from the banks.

An additional agreement was entered into dated May 1, 1972 called the Miscellaneous Covenants Agreement which provided, inter alia, that the appellant and Bathurst would each become entitled to cash payments in the amount of $500,000 should Bulkley Valley’s gross cash flow, as defined, in its fiscal periods from February 1,1972 to December 31, 1981, exceed the aggregate sum of $9.3 million. In the event, each became entitled to that sum.

On October 4, 1977, Bathurst purchased from the banks the remaining Series "B" Notes held by them, which at that time totalled the principal sum of $6,385,000. On the same date, the appellant entered into an agreement with Bathurst under which the appellant acknowledged its indebtedness to Bathurst for the sum of one-half of $6,385,000, i.e. $3,192,500. It agreed to pay that amount, together with interest at the rate of one and one-half per cent above prime, to Bathurst in four equal instalments of $690,000 each and one final instalment, on January 1,1982, of $432,500. The appellant, pursuant to the same agreement, transferred to Bathurst its Series “B” Notes in the principal sum of $2,760,000 for $1 and as well, with ten per cent convertible funds having a face value of $1,866,400, for a gross purchase price of $5.

Further, pursuant to the October 4, 1977 agreement, the appellant received the sum of $500,000 in satisfaction of its rights under the Miscellaneous Covenants Agreement. Both the appellant and Bathurst entered agreements with Northwood and the banks terminating any future rights and obligations they might have had under the financing arrangements of May 1, 1972, including the Financing Agreement itself, the Upward Price Adjustments Agreement and the Miscellaneous Covenants Agreement.

In 1978, the appellant exercised its right of pre-payment of the balance of the principal amounts payable to Bathurst under the October 4, 1977 agreement. In addition, the following payments, representing its portion of the interest due on the principal sum remaining unpaid under the October 4, 1977 agreement with Bathurst, were made to Bathurst in the 1977 and 1978 taxation years:

1977 — 1 /2 per cent above prime — $ 75,898

1978 — 1'/2 per cent above prime — $105,937

The appellant had been able to accomplish this pre-payment by borrowing money from the Bank of Montreal at an interest rate of one-half per cent above prime. The following interest payments were made to the Bank of Montreal in the 1978 and 1979 taxation years for the use of those borrowed funds:

1978 — /2 per cent above prime — $148,692

1979 — /2 per cent above prime — $238,604

For its 1977, 1978 and 1979 taxation years, the appellant treated all the principal amounts paid in respect of the Series “B” Notes as capital losses, half of which were either claimed as allowable capital losses in the year or carried forward for future years.

By notices of reassessments dated June 2, 1981 the Minister of National Revenue disallowed the deduction of the interest payments referred to in the two preceding paragraphs in the respective sums of $75,898 for 1977, $254,629 for 1978 and $238,604 for 1979 in computing the appellant's taxable income. The Minister treated the amounts of $75,898 for 1977 and $127,314 for 1978 and $119,302 for 1979 as allowable capital losses. The appeal of the appellant from these reassessments was dismissed by Cullen, J. in the Trial Division. It is from that judgment that this appeal is brought.

The Issues:

Counsel for the appellant in his memorandum of fact and law referred to a number of errors allegedly made by the trial judge in his reasons for judgment. However, I think it fair to say that in the argument of the appeal the presence of those errors did not derogate from the two basic issues which he raised, namely:

(a) were the interest payments in issue properly deductible in the ordinary course, in the computation of the appellant's taxable income in the 1977, 1978 and 1979 taxation years in accordance with general commercial principles, since their deduction was not prohibited by any of the provisions of the Income Tax Act ("the Act"), or

(b) alternatively, were they deductible in accordance with subparagraph 20(1)(c)(i) of the Act?

The Legislation

For the three taxation years in issue in the appeal, the relevant statutory provisions of the Act were:

Section 18. General limitations.

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

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

(b) Capital outlay or loss. — an outlay, loss or replacement of capital, a payment on account of capital or an allowance in respect of depreciation, absoles- cence or depletion except as expressly permitted by this Part;

Section 20. Deductions permitted in computing income from business or property’

ty.

(1) Notwithstanding paragraphs 18 (1)(a), (b) and (h), in computing a taxpayer's income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:

(c) Interest. — an amount paid in the year or payable in respect of the year (depending upon the method regularly followed by the taxpayer in computing his income), pursuant to a legal obligation to pay interest on

(i) borrowed money used for the purpose of earning income from a business or property (other than borrowed money used to acquire property the income from which would be exempt or to acquire a life insurance policy).

Issue 1

Deductibility on general commercial principles

It was counsel for the appellant's contention, as stated in his memorandum of fact and law, that:

. . . the Appellant's business was and continues to be the operation, administration and financing of companies that carry on, broadly, the pulp and paper business. To this end it provided financial, administrative and technical assistance to companies in which it had an interest. From this business it earned and reported substantial income in the form of interest and dividends. In the course of and as part of this ongoing business it became involved with Bulkley Valley and in the course of its administration of that company and the provision to it of financial services, it incurred a number of obligations. Bulkley Valley failed but the overall business of the Appellant continued. The restructuring of the arrangements that followed the failure of Bulkley Valley was a necessary incident of the business.

In counsel's view, again as expressed in his memorandum of fact and law:

The submission that the interest is deductible in the ordinary course and is not dependent upon compliance with paragraph 20(1)(c) of the Act is based upon two separate propositions:

(a) Interest, like any other expense, may, depending on the facts of a particular case, be an ordinary cost of doing business and deductible in computing income under Section 9 of the Income Tax Act. For example, banks, financial institutions and many other taxpayers need not rely upon the intricacies of paragraph 20(1)(c) to deduct interest. It is as necessary an incident of this business as the payment of salaries.

(b) Paragraph 20(1)(c) is not a complete code relating to interest. Its function is to permit the deduction of interest that would not otherwise be deductible because of paragraph 18(1)(a) or (b).

Quite aside from the fact that the appellant adduced no evidence, expert or otherwise, as to the existence of the commercial practice upon which it purports to rely, it must satisfy the Court that the interest expense for which deductibility is claimed was incurred by it for the purpose of gaining or producing income from a business or property and was not incurred by borrowing to acquire capital assets or to provide working capital. If it is in the latter category then a long line of jurisprudence has held that a statutory basis must be found for such interest expense to be properly deductible. The existence of a general commercial practice would thus, as I see it, be irrelevant. Two of the cases relied upon by appellant's counsel* [1] to support his contention are clearly distinguishable, in my view, on their facts in that the taxpayers in each case were found to be utilizing the funds in issue in the course of carrying on their respective trades. As well, in the Farmer case, the interest paid for the use of such funds was properly deductible as an expense for the use of the funds by which the taxpayer made a profit.

Nor does the Consolidated Mogul Mines Ltd. case, [1968] C.T.C. 429; 68 D.T.C. 5284, which is the third case relied on by the appellant in support of this branch of its argument, have any relevance to the issues herein except to the extent that the finding therein that the source of income of a corporation is an important element to be considered in determining its principal business, but not the only one or necessarily the determinative one, may be relevant.

It would seem, therefore, that the appropriate inquiry is to ascertain the purpose for which the money, for which the interest was paid, was used. That this is the proper inquiry seems clear from what was said by Chief Justice Dickson in the recent judgment of the Supreme Court of Canada in The Queen v. Bronfman, [1987] 1 C.T.C. 117 at 124; 87 D.T.C. 5059 at 5064, when he observed that:

It is perhaps otiose to note at the outset that in the absence of a provision such as paragraph 20(1)(c) specifically authorizing the deduction from income of interest payments in certain circumstances, no such deductions could generally be taken by the taxpayer. Interest expenses on loans to augment fixed assets or working capital would fall within the prohibition against the deduction of a "payment on account of capital” under paragraph 18(1)(b); Canada Safeway Ltd. v. M.N.R., [1957] S.C.R. 717; [1957] C.T.C. 335, at 722-23 (C.T.C. 339-40) per Kerwin, C.J. and at 727 (C.T.C. 344) per Rand J.

. . . Not all borrowing expenses are deductible. Interest on borrowed money used to produce tax-exempt income is not deductible. Interest on borrowed money used to buy life insurance policies is not deductible. Interest on borrowings used for non-income earning purposes, such as personal consumption or the making of capital gains is similarly not deductible. The statutory deduction thus requires a characterization of the use of borrowed money as between the eligible use of earning non-exempt income from a business or property and a variety of possible ineligible uses. The onus is on the taxpayer to trace the borrowed funds to an identifiable use which triggers the deduction. Therefore, if the taxpayer commingles funds used for a variety of purposes only some of which are eligible he or she may be unable to claim the deduction: see, for example, Mills v. M.N.R., [1985] 2 C.T.C. 2334; 85 D.T.C. 632 (T.C.C.); No. 616 v. M.N.R., 22 Tax A.B.C. 31; 59 D.T.C. 247 (T.A.B.).

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

Bearing those instructions in mind, the history of the borrowing upon which interest was paid in this case must be examined. Paragraph 6 of the amended statement of claim, which was verified in the partial agreed statement of facts, shows the origin of the appellant's original obligations:

6. After the sawmill had been built and was in operation, it was determined that Bulkley Valley required additional working capital and needed assistance as well in the completion of the Sawmill Development. In the result, the Plaintiff and Bathurst each guaranteed one-half of the bank loans made to Bulkley Valley under Bank Loan Agreements dated April 18, 1969 and October 6, 1970, to a maximum guarantee of $10,000,000 each. The plaintiff did not receive a fee from Bulkley Valley for providing the guarantee.

Paragraphs 8, 9, 10(e) and 11 trace the subsequent events relating to the bank guarantees:

8. In 1972, Northwood Pulp Limited ("Northwood"), a subsidiary of Noranda Mines Limited, agreed to purchase the shares of Bulkley Valley from the Plaintiff and Bathurst so as to consolidate the Bulkley Valley operations with its own operations in the region.

9. In order to facilitate this purchase it was necessary for the previous financing arrangements for Bulkley Valley to be reorganized and this was done pursuant to the Financing Agreement dated May 1, 1972 made between the Plaintiff, Bathurst, Northwood, Bulkley Valley and the Bank of Montreal, the Royal Bank of Canada and the Mercantile Bank of Canada.

10. Under these new financing arrangements dated May 1, 1972:

(e) the remaining Bulkley Valley bank loans, in the amount of $11,905,000, which were still guaranteed as to one-half each by the Plaintiff and Bathurst, were refinanced with the proceeds of the issue by Bulkley Valley of Series B Notes, bearing interest at the rate of 1 /2% above prime, to the Bank of Montreal, the Royal Bank of Canada and the Mercantile Bank of Canada.

11. In recognition of their obligations under the original bank guarantees, the Plaintiff and Bathurst each agreed with the banks both to guarantee and to pay one-half of the amounts owing in respect of the Series B Notes including principal and interest and the banks agreed to assign the Series B Notes to the Plaintiff and Bathurst as and when they were paid by the Plaintiff and Bathurst. The Plaintiff did not receive a fee from Bulkley Valley for entering into this agreement with the banks.

A Financing Agreement dated May 1, 1972 was entered into between Northwood Pulp Limited ("Northwood") as purchaser of Bulkley Valley, Bowater and Bathurst as vendors of the shares thereof, and Bulkley Valley itself. Recital C in the agreement is referrable to the bank guarantees, inter alia. It reads:

C. Pursuant to and as an integral part of said offer and acceptance Northwood, Bowaters and Bathurst have made arrangements to re-organize and refinance the term indebtedness of Bulkley Valley as set forth and described on Schedule III hereof on the terms and conditions and as provided herein.

Paragraph 3 of the agreement records the obligation of the Royal Bank of Canada, the Bank of Montreal and Mercantile Bank of Canada ("the banks") to subscribe for and purchase Series B Notes securing principal amounts equal to /s, /s and /s of the Series B Notes respectively to a maximum of $5 million, $5 million, and $2.5 million respectively.

Clause (d) of the paragraph states that:

(d) The total amount of Series "B" Notes to be issued is an amount equal to the amount required to discharge all principal and interest outstanding under the loans and indebtedness described in Schedule III hereto minus the amount of the Northwood debt.

The amount of the Northwood debt is defined in the agreement but is not relevant in this analysis.

Paragraphs 5 and 6 are important. They read:

5. Use of Proceeds From Series "B" Notes

The entire proceeds from the sale of Series "B" Notes as aforesaid shall be utilized at Closing by Bulkley Valley firstly to repay to Montreal, Royal and Mercantile the balance of the indebtedness referred to in Clause 4 hereof, and secondly to repay and discharge the indebtedness of Bulkley Valley described in Schedule III attached hereto.

6. Guarantee and Covenant

(a) Bowaters covenants and agrees with each of Montreal, Royal and Mercantile to guarantee payment of and to pay to each of Montreal, Royal and Mercantile when due, one-half of all amounts secured by Series "B" Notes held from time to time by each of Montreal, Royal and Mercantile;

(b) Bathurst covenants and agrees with each of Montreal, Royal and Mercantile to guarantee payment of and to pay to each of Montreal, Royal and Mercantile when due, one-half of all amounts secured by Series "B" Notes held from time to time by each of Montreal, Royal and Mercantile;

(c) All of such guarantees and covenants shall each be in form reasonably required by each of Montreal, Royal and Mercantile.

The agreement provides further that the banks will transfer to Bowater and Bathurst Series "B" Notes securing amounts equal to the amounts of principal paid and satisfied by them.

Counsel for the appellant relied heavily on what he described as Bowater's absolute obligation to pay the banks as opposed to being called upon to pay them only as guarantors after Bulkley Valley failed to meet its primary obligations to the banks. While I am not at all sure that that factor has much effect on the ascertainment of the purpose for which Bowater incurred its obligations, for sake of completeness I will deal with it. Paragraph 8 of the agreement upon which counsel relied is set forth hereunder, in full:

8. Failure of Bulkley Valley to Pay Under the Said Series "B” Notes

If all or part of all amounts due or falling due (including principal and interest) in respect of the said Series "B" Notes is not paid to Montreal, Royal and Mercantile by Bulkley Valley when due, then:

(a) if the Cash Profit of Bulkley Valley for the Fiscal Period in which such due date falls exceeds the amounts (including principal and interest) due or falling due within such Fiscal Period and any previous Fiscal Period, and which remains unpaid pursuant to and under the Series "A" Notes, then Montreal, Royal and Mercantile shall have the right to demand and receive payment from Bulkley Valley of the amounts so due or falling due under the said Series “B” Notes up to the amount of such excess; but

(b) Montreal, Royal and Mercantile shall have the right to demand and receive from Bowaters and Bathurst pursuant to the guarantees provided for in Clause 6 hereof, payment of the amounts so due or falling due under the said Series "B" Notes and unpaid, whether or not the Cash Profit exceeds the amounts due or falling due pursuant to and under the Series "A" Notes;

(c) Each of Montreal, Royal and Mercantile covenants and agrees that, save for demanding payment from Bulkley Valley of the amount due, it shall have no recourse against Bulkley Valley for the amounts due under and secured by the Series "B" Notes, except as provided in subclause (a) of this Clause 8 and in Clause 13.

[Emphasis added.]

Guarantees also dated May 1, 1972 were entered into with each of the banks by Bowater obligating it to pay 50 per cent of all amounts of principal and interest due or falling due in respect of each of the Series “B” Notes at any time held by the banks "which principal or interest is not paid by the Customer when due . . .”. It also provided in paragraph 7 that:

The Bank shall not be obliged to exhaust its recourse against the Customer or other persons or any securities it may at any time hold before being entitled to payment from Bowaters [sic] pursuant to this Guarantee and Covenant.

The mere right of the bank not to have to exhaust its recourse against the Customer, does not convert an obligation as a guarantor to that of a primary debtor as urged by counsel for the appellant. That right must be read in the context of the balance of the document which clearly characterizes the appellant as a guarantor.

From all of the foregoing, I think that it is abundantly clear that any principal and interest payments which might have been made by the appellant to the banks, on the original bank loans, would have resulted from the appellant having guaranteed the loans made to Bulkley Valley to enable it to complete its sawmill development and to provide it with sufficient working capital until it had been completed. Without question, all such payments, both principal and interest, would have been capital in nature. It is, in my view, equally clear from the documentation dated May 1, 1972, the partial agreed statement of facts and the appellant's amended statement of claim, that the Series "B" Notes were issued by Bulkley Valley to the banks as security for the balance of its outstanding original indebtedness to the banks which, as I have noted, was incurred for capital purposes. The refinancing did not change its character or the purpose for which the indebtedness was incurred. Nor did it change the appellant's status as a guarantor. Being for capital purposes the interest costs relating thereto were also Capital in nature. The fact that the appellant was in the business of rendering financial and other services to its subsidiaries and affiliates and that recourse might be had directly to it for non-payment by Bulkley Valley do not, in the circumstances of this case, render the interest costs arising out of its guarantee, revenue disbursements. The appellant's submissions on this branch of the appeal, accordingly, must fail.

Issue No. 2

Deductibility under subparagraph 20(1)(c)(i)

Chief Justice Dickson in the Bronfman case, supra, at page 124 (D.T.C. 5065), made this preliminary observation about paragraph 20(1)(c):

It is perhaps otiose to note at the outset that in the absence of a provision such as s. 20(1)(c) specifically authorizing the deduction from income of interest payments in certain circumstances, no such deductions could generally be taken by the taxpayer. Interest expenses on loans to augment fixed assets or working capital would fall within the prohibition against the deduction of a "payment on account of capital, under paragraph 18(1)(b); Canada Safeway Ltd. v. M.N.R., [1957] S.C.R. 717; [1957] C.T.C. 335, at 722-23 (C.T.C. 339-40) per Kerwin, C.J. and at 727 (C.T.C. 344) per Rand, J.

It will be recalled that on October 4, 1977 Bathurst purchased from the banks the remaining Series "B" Notes held by them in the principal amount of $6,385,000. On the same date the appellant entered into an agreement with Bathurst under which it acknowledged its indebtedness to Bathurst for the sum of $3,192,500, being one-half of the principal balance of the Series "B" Notes, together with interest at the rate of one and one-half per cent above prime. Under the agreement the appellant was required to make four annual principal payments of $690,000 each on January 1 of each year commencing in 1978 and a fifth payment of $432,500 on January 1, 1982. The appellant also assigned to Bathurst all of the Series "B" Notes which it had acquired and ten per cent convertible notes in the sum of $1,866,400 each for nominal consideration.

In 1978, the appellant prepaid the above sums. Thus, as earlier shown, the following payments representing the portion of the interest due on the principal sum remaining unpaid under the October 4,1977 agreement were made in the 1977 and 1978 taxation years to Bathurst:

1977 (1'/2 per cent above prime) — $ 75,898

1978 (1'/2 per cent above prime) — $105,937

In order to exercise its right of prepayment, the appellant borrowed funds from the Bank of Montreal at an interest rate of one-half of one per cent above prime. Therefore, the following interest payments were made to the Bank of Montreal in the 1978 and 1979 taxation years:

1978 ( /2 per cent above prime) — $148,692

1979 ( /2 per cent above prime) — $238,604

The appellant deducted the payments of interest both to Bathurst and the Bank of Montreal in computing its taxable income for 1977, 1978 and 1979 taxation years. These are, of course, the payments which were disallowed by the Minister under the reassessments which are the subject matter of this appeal.

(a) I shall deal first with the interest payments to Bathurst. To be deductible under subparagraph 20(1)(c)(i) they must meet all of the conditions imposed thereby. The paragraph specifies that the funds on which the interest is payable must be money which has been "borrowed" by the taxpayer under a "legal obligation to pay interest".

Counsel for the appellant argued that the payments made were not pursuant to the guarantee to the banks, but were made, rather, as a direct and immediate obligation to pay principal and interest pursuant to the October 4,1977 agreement. The obligation to pay was not contingent upon non-payment by anyone else. In passing, I may say that I cannot agree with the learned trial judge that this interpretation of the deal is "far-fetched". However, that observation does not mean that it meets the tests imposed by subparagraph 20(1)(c)(i).

Counsel ingeniously relied on paragraph 3 of the appellant's agreement with Bathurst of October 4,1977 as supporting his contention that his client was a borrower from Bathurst with the result that interest paid on the borrowing fell within the ambit of subparagraph 20(1)(c)(i). That paragraph reads as follows:

3. Bowater hereby acknowledges and agrees that as a result of the purchase by Bathurst from Montreal, Royal and Mercantile of the Series "B" Notes in the principal amount of $6,385,000.00 it is indebted to Bathurst in the principal sum of $3,192,500.00 and hereby undertakes and agrees to repay such sum to Bathurst in the following amounts upon the following dates, in lawful money of Canada at the head office of Bathurst in Montreal, Quebec:

January 1, 1978	$690,000.00
January 1, 1979	$690,000.00
January 1, 1980	$690,000.00
January 1, 1981	$690,000.00
January 1, 1982	$432,500.00

together with interest on the unpaid balance thereof commencing on the 4th day of October, 1977 at the prime rate of Montreal, plus 42% per annum payable monthly in arrears at the same place. [Emphasis added.]

There is no doubt that by virtue of that agreement Bowater became indebted to Bathurst. But there is equally no doubt that the indebtedness arose out of Bathurst’s purchase of the Series “B” Notes and the obligation of Bowater, pursuant to the May 1,1972 agreement, to purchase 50 per cent of the banks' holding of Series "B" Notes as and when called upon. Implicit in that obligation is the requirement that if either party paid off the banks in full, the other party would be liable to the purchaser for its share of the payout. The October 4,1977 agreement, in effect, acknowledged this obligation by Bowater and, as well, included other consideration for finally releasing Bowater from further obligations under the 1972 Financing Agreement, as evidenced by the release executed on the same day, October 4, 1977, by Bathurst, Bowater and Northwood. The recitals in that release trace the series of events leading to execution of the release and can leave no doubt that the origin thereof, as far as Bathurst and Bowater were concerned, was the obligations to the bank in respect of the Series “B” Notes which are capital in nature.

As Chief Justice Dickson said in the Bronfman case, supra, at page 129 (D.T.C. 5067) of the report:

In my view, the test of the Act requires tracing the use of borrowed funds to a specific eligible use . . .

In this case that eligible use would have to be ”. . for the purpose of earning income from a business or property . . .”. Since the tracing discloses that the use was not for that purpose, the interest paid to Bathurst in 1977 and 1978 is not deductible pursuant to subparagraph 20(1)(c)(i) of the Act.

(b) I turn now to the interest payments made to Bathurst and the Bank of Montreal in the appellant’s 1978 and 1979 taxation years.

I do not think it necessary to engage in a discussion, as did the trial judge and as did counsel for the respondent in his submissions, as to whether those interest payments not being for the appellant's business, per se were not deductible. Counsel for the appellant pointed out that he had never argued that proposition as a basis for his submission as to the propriety of their deductibility. He rested his case wholly on the contention that they were properly deductible by Bowater as a necessary incident of the ongoing obligations of its business and, thus, were for the purpose of earning its income.

For the reasons which I have given in the other branches of the appeal, I do not agree with this contention so that the appellant also fails on this branch of its argument.

Summary

As to the whole of the appeal, I think that the words of Lord Pearce in B.P Australia Ltd. v. Commissioner of Taxation of the Commonwealth of Australia, [1966] A.C. 224 (P.C.) at 264; [1965] 3 All E.R. 209 at 218, oft quoted in capital versus revenue situations, ought not to be lost sight of on the facts of this case:

The solution to the problem is not to be found by any rigid test or description. It has to be derived from many aspects of the whole set of circumstances some of which may point in one direction, some in the other. One consideration may point so clearly that it dominates other and vaguer indications in the contrary direction. It is a commonsense appreciation of all the guiding features which must provide the ultimate answer. Although the categories of capital and income expenditure are distinct and easily ascertainable in obvious cases that lie far from the boundary, the line of distinction is often hard to draw in border line cases; and conflicting considerations may produce a situation where the answer turns on questions of emphasis and degree. That answer:

depends on what the expenditure is calculated to effect from a practical and business point of view rather than upon the juristic classification of the legal rights, if any, secured employed or exhausted in the process:

per Dixon, J. in Hallstroms Pty. Ltd. v. Federal Commissioner of Taxation. [19] As each new case comes to be argued felicitous phrases from earlier judgments are used in argument by one side and the other. But those phrases are not the deciding factor, nor are they of unlimited application. They merely crystallise particular factors which may incline the scale in a particular case after a balance of all the considerations has been taken.

The National Citizens Coalition Inc. et al.

As has been seen, my commonsense appreciation of all of the factors including, most importantly, the guidance given by the Supreme Court of Canada in the Bronfman case, has led me to conclude that the interest payments in issue were made on capital account.

Accordingly, I would dismiss the appeal with costs.

Appeal dismissed.