Gruyich Services Inc. (formerly Gru-Reco Limited) v. Minister of National Revenue, 91 DTC 159, [1991] 1 CTC 2139 (TCC)

Sobier, T.C.J.:—The appellant appeals reassessments made by the Minister of National Revenue (the" Minister") with respect to the appellant's 1980 to 1985 inclusive taxation years whereby the Minister disallowed as a deduction for those years of interest paid in the following amounts:

on the basis that they did not constitute interest paid on money borrowed for the purpose of gaining or producing income from a business or property within the meaning of paragraph 20(1)(c) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act").

The deduction was disallowed on the assumption by the Minister that such interest was interest on money borrowed and used for the purpose of paying dividends to the shareholders of the appellant. The amounts of the dividends paid are set out below:

The provisions of paragraph 20(1)(c) of the Act read as follows:

20. (1)(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),

(ii) an amount payable for property acquired for the purpose of gaining or producing income therefrom or for the purpose of gaining or producing income from a business (other than property the income from which would be exempt or property that is an interest in a life insurance policy).

The appellant does not deny that a portion of the moneys borrowed was used to pay dividends and states that the issue is what portion of the moneys borrowed was used to pay dividends and therefore the interest payment in respect of which is non-deductible and which portion was used for the purpose of earning income from its business the interest payments in respect of which [are] deductible?

The only witness called on behalf of the appellant was Mr. George Johnson, a tax accountant with the appellant's auditors, Crawford, Smith & Swallow, Chartered Accountants.

Mr. Johnson gave evidence tracing the borrowed funds and categorized them as to their original use or purpose.

The uncontroverted evidence of Mr. Johnson was that the only moneys borrowed to pay dividends had as their source the appellant's borrowing under what Mr. Johnson labelled the Current Account and the Credit Line which were borrowings from the company's bankers by way of loan or overdraft and that only part of the Current Account and Credit Line was used for the payment of dividends and the balance was used for what can be referred to as business purposes.

On two occasions, the total indebtedness of the appellant was refinanced. Once in 1980 by what was called the "Term Loan” and in 1984 by the "13.75% Mortgage".

In carrying out his calculations and tracing the borrowed moneys and the interest paid thereon, Mr. Johnson always characterized the same amount of money borrowed for dividend payments as such, even though as a result of refinancing the borrowing took on different names; i.e., of the $2,050,000 term loan he segregated out the amounts which were originally borrowed under the Current Account and Credit Line for the purpose of paying dividends and he similarly attributed the interest paid on these moneys as interest paid on moneys borrowed to pay dividends.

He analyzed the amounts of borrowing on a monthly basis. He then reviewed dividend payments on a monthly basis. In the next step in the calculation, he reviewed the status of the Current Account and the Credit Line or their successors. Mr. Johnson then made the assumption that if there were an increase in this type of borrowing, the increase was used to pay dividends to the extent of the dividends paid. In making these assumptions, Mr. Johnson did not take into account any positive balance in the Current Account or the Credit Line which was, of course, an assumption to the detriment of the appellant. His evidence was clear that in calculating the interest paid on moneys borrowed for dividend payment, Mr. Johnson took the worst case scenario.

If there were a repayment or reduction in the amounts in the Current Account or Credit Line, the reduction could have been allocated in three ways:

1. wholly to repay moneys borrowed for dividend payment,

2. wholly to repay moneys borrowed for business purposes, or

3. on a pro rata basis between dividends and business.

Mr. Johnson chose the third alternative and in his tracing, he allocated the pro rata share of the interest paid to dividend payment and the balance to the business borrowings.

As a result of the foregoing methodology, Mr. Johnson was able for each of the taxation years in question to allocate an amount of interest attributed to that part of the borrowing which was used for the payment of dividends. Thus, in 1980, $23,834 was attributed to that account.

The interest paid on account of moneys borrowed for dividend payments calculated by Mr. Johnson and Revenue Canada were as follows:

The appellant acknowledges that the amounts showing under Mr. Johnson's calculations are the amounts that are non-deductible.

When asked under cross-examination whether it was crucial to his calculation, that if there were no increase in borrowing each year in the Current Account and the Credit Line, then it followed that no moneys were borrowed to pay dividends. Mr. Johnson replied in the affirmative but went on to say that he relied on the logic that the money had to come from somewhere and if funds were not borrowed then they came from another source.

The Minister takes the position that the dividends must come from profits and in each year when the appellant was in a loss position, the interest paid on the funds borrowed to pay dividends was not deductible. The Court sees no merit in this argument since corporations are entitled to declare and pay dividends provided that there is no breach of the appropriate corporate law.

In argument, both appellant's counsel and the Minister's counsel spent a great deal of time dealing with the issue of original use and current use of borrowed funds in order to determine the deductibility of the interest paid. In that regard, the Court was referred to Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32; [1987] 1 C.T.C. 117; 87 D.T.C. 5059 (S.C.C.); Lakeview Gardens Corporation v. M.N.R., [1973] C.T.C. 586; 73D.T.C. 5437 (F.C.T.D.); and TransPrairie Pipelines Ltd. v. M.N.R., [1970] C.T.C. 537; 70 D.T.C. 6351 (Ex.Ct.).

However, from the evidence it is clear that changes in the use of funds by the appellant is not the issue. That portion of the moneys borrowed to pay dividends and the interest paid on such moneys borrowed was always characterized as being non-deductible. Therefore, if this amount is determinable, the remaining interest paid would be deductible since there is no evidence adduced to contradict Mr. Johnson's evidence that the remaining interest was paid on account of moneys borrowed and used for business purposes and deductible under paragraph 20(1)(c) of the Act.

It is the Minister's position that if the borrowed funds used for eligible and ineligible purposes were commingled, the appellant would be unable to claim the deduction. See Bronfman v. The Queen, supra. Chief Justice Dickson said at pages 124-25 (D.T.C. 5064):

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.)

[Emphasis added.]

Has the appellant been able to trace the two types of borrowed funds? The calculations made by Mr. Johnson were detailed and the methodology employed was reasonable in all of the circumstances. The Court finds that in addition, the assumptions made by him were well founded. His calculations have permitted the Court to determine the amount of money borrowed for the purpose of paying dividends and the amount of interest attributable thereto and accordingly, the remaining amount of interest deductible pursuant to paragraph 20(1)(c) of the Act.

In No. 616 v. M.N.R. (1959), 22 Tax A.B.C. 31; 59 D.T.C. 247, the appellant was unable to distinguish loans obtained for ineligible purposes from loans obtained to be used for eligible purposes. In the present appeal the appellant has clearly been able to trace the funds and has discharged the onus to trace the borrowed funds to identifiable uses.

The commingling of funds is not fatal to the appellant's case. Chief Justice Dickson in Bronfman, supra, stated that the appellant may be unable to claim the deduction if there is commingling. Even though there was commingling, the borrowed funds have been traced to identifiable uses.

Accordingly, the appeal is allowed and the assessments are referred back to the Minister for reconsideration and reassessment on the basis that, of the amounts of interest disallowed as a deduction by the Minister, the appellant may deduct the following interest payments in the enumerated years pursuant to paragraph 20(1)(c) of the Act.