The Queen v. MerBan Capital Corp. Ltd., 89 DTC 5404, [1989] 2 CTC 246 (FCA)

lacobucci, C.J.: — This is an appeal by the Minister of National Revenue ("Minister") from the judgment of the Federal Court-Trial Division, which dismissed with costs an appeal by the Minister from a judgment of the Tax Review Board. The effect of both the judgment of the Trial Division and of the Tax Review Board was to permit each of MerBan Capital Corporation Limited ("MerBan"), George H. Montague ("Montague"), and Michael F.K. Carter ("Carter") to deduct in computing their income for tax purposes certain amounts paid to the Toronto-Dominion Bank (the "Bank"). [1] The appeals before the Federal Court-Trial Division were heard on common evidence and it is agreed that the result in this appeal with respect to MerBan will also determine the result of the appeals with respect to Montague and Carter (MerBan, Montague and Carter are sometimes referred to herein as the "Respondents").

Facts

The facts are somewhat complicated but are of considerable importance. MerBan, during the relevant years in question, was engaged in the business of merchant banking which was conceded at trial by the Minister and found as a fact by the learned trial judge. MerBan invested in corporations and made certain services available to them. Its objects included, among other things, making active equity investments for the purposes of acquiring control in growing companies, making its resources otherwise available to prospective clients, arranging or providing financing, and providing financial and management expertise for the employment of a variety of experts and consultants. MerBan did not trade in company shares but invested in them and when it disposed of an investment in shares, it reported the disposition as being on account of capital on its income tax returns. Fees earned from the provision of services to companies in which MerBan had invested were received by MerBan Securities Ltd., a subsidiary of MerBan.

Carter and Montague were officers of MerBan. As officers, they along with other officers of MerBan were beneficiaries of a trust with a company named Casamont Ltd. as trustee, which generally participated with MerBan to the extent of ten per cent in any investment which MerBan undertook.

In the late summer of 1972, MerBan had become interested in participating in investments surrounding the Mackenzie River Pipeline Project which, at the time, were among attractive business opportunities in Canada. As a result, MerBan became interested in making an investment in a public company called Kaps Transport Ltd. ("Kaps") that operated out of Western Canada and the Northwest Territories. MerBan hoped that by making a significant equity investment in Kaps, it could introduce more efficient management techniques and thereby increase the earnings of Kaps and provide dividend income. MerBan also hoped to enhance its reputation as an institutional merchant banker and to generate financing and consulting fees directly to MerBan and its associated companies.

On September 21, 1972, MerBan acquired options to purchase 450,000 common shares of Kaps at $10 per share from its controlling shareholders, the three Kapchinsky brothers. It was also agreed that if MerBan exercised the options, the Kapchinsky brothers would place the balance of their shares of Kaps, in respect of which MerBan did not have an option to acquire, in a voting trust over which MerBan would have absolute control.

In order to limit its liability and to obtain financing, MerBan decided not to purchase the Kaps shares itself, but to incorporate a subsidiary and have the subsidiary purchase the shares and borrow the majority of the funds necessary to purchase the shares. The purchase of the 450,000 shares under the option at an agreed price of $10 per share represented a $4.5 million investment to MerBan of which it was able to commit only $1,250,000 of its own funds such that the balance required financing.

MerBan thus caused to be incorporated two subsidiary corporations, one called 1216825 Investments Ltd., which name was subsequently changed to MKH Investments Ltd. ("MKH"), and MerBan-Kaps Holdings Ltd. ("Holdings"). The subsidiary corporations, MKH and Holdings, had the same head office, auditors and law firm as MerBan, and generally the same offices. The subsidiaries did not engage in any transaction other than those relating to the acquisition of the Kaps shares.

The shares of MKH were owned in the following proportions:

Reinhold Kapchinsky acquired ten per cent of the shares of MKH because he was the President of Kaps and MerBan felt that it was important that he continue to have an interest in Kaps. Shares of MKH were purchased by the shareholders for an aggregate price of $1.25 million. The shares of Holdings were owned 100 per cent by MKH, which purchased the shares of Holdings for a purchase price of $4. Although MerBan did not own all the outstanding shares of MKH, and MKH in turn was the sole owner of the shares of Holdings, I refer to both MKH and Holdings as subsidiaries of MerBan.

Holdings purchased the 450,000 Kaps shares for an aggregate purchase price of $4.5 million dollars. It obtained the necessary purchase funds through a loan of $1 million from the Bank under the terms of a 6 per cent income debenture, $4 from the sale of its shares to MKH and the balance of $3.5 million less $4 through an interest-free loan from MKH. MKH in turn obtained the $3.5 million, which was transferred to Holdings, in the following manner. MKH borrowed $2.25 million from the Bank on a term loan at a rate of prime plus one per cent. The remaining $1.25 million was obtained from the sale of MKH's shares to its shareholders: MerBan, Casamont Ltd. and Reinhold Kapchinsky (the “MerBan Group”).

To obtain the above-mentioned loans from the Bank, Holdings, MKH and the MerBan Group, were required to do the following:

(i) Holdings agreed to repay the $1 million loan in accordance with the terms of the income debenture and to pay interest at 6 per cent when required under the debenture;

(ii) Holdings was required to give MKH a promissory note for the approximately $3.5 million it had borrowed from MKH;

(iii) Holdings was required to guarantee to the Bank that MKH would pay to it the principal and interest on the $2.25 million loan borrowed by MKH from the bank;

(iv) Holdings was required to give to the Bank an option to purchase 150,000 Kaps shares at a purchase price of $10 per share;

(v) Holdings was required to pledge to the Bank the 450,000 Kaps shares purchased by it as security for the $1 million income debenture of Holdings and the $2.25 million loan of MKH;

(vi) In turn, MKH agreed to repay the $2.25 million borrowed by MKH from the Bank together with interest at prime plus one per cent, and MKH was required to pledge to the Bank the shares of Holdings and the promissory note of Holdings in the amount of approximately $3.5 million as security for the $2.25 million loan from the Bank to MKH;

(vii) The MerBan Group, in a document referred to as the "deficiency agreement" and in which they were collectively referred to as guarantors, were required to “unconditionally guarantee to and covenant and agree with the Bank” that they will pay or cause the borrower [MKH] to pay all interest up to $500,000 on the loan as and when the same shall from time to time become due and payable in accordance with the terms of the loan agreement relating to the $2.25 million loan from the Bank to MKH. In the same deficiency agreement, the MerBan Group also agreed "that [t]hey will pay or cause to be paid to the Bank” the interest on the $1 million 6 per cent income debenture which Holdings issued to the Bank.

The Bank required the MerBan Group to be liable for the payment of interest on MKH's loan as it was believed that MKH would not have sufficient cash flow to pay the interest on its loan. However, the liability was limited to $500,000 as this would approximate the total interest owing for the term of the loan, and the MerBan Group's liability was limited to interest only and did not extend to the principal of the loan.

In furtherance of the above-mentioned transactions, the MerBan Group had its subsidiary corporation, Holdings, purchase the Kaps shares for $4.5 million on or about October 16, 1972. As stated, the MerBan Group was required to invest only $1.25 million and to “guarantee” the payment of $500,000 of interest.

The results of the investment in and business prospects of Kaps did not materialize as the parties had hoped for or expected. As interest became due on the loan owing by MKH to the Bank, the Bank would debit the account of MKH for the interest owing. This would place MKH's Bank account in an overdraft position and the Bank would notify MerBan of this and MerBan would write a cheque to MKH for the interest. On some occasions the cheque for interest went directly to the Bank instead of to MKH.

In preparing its financial statements and filing its income tax returns for the 1972, 1973, and 1974 taxation years, MKH treated the amounts paid by the MerBan Group on account of the MKH loan from the Bank as loans made to it by its shareholders. In filing its income tax returns for the 1972, 1973, and 1974 taxation years, MKH deducted the interest payments made on account of its loan from the Bank as an expense, and consequently reported a loss in each year. In its financial statements for 1975 and its tax return for the 1975 taxation year, MKH revised the entries for the previous years by removing the accumulated loss and removing the shareholder liability. This was done because it was decided that MerBan would file its 1974 return of income claiming the interest payments on the MKH loan as an expense in computing MerBan's income.

MerBan, Montague, and Carter in filing their income tax returns sought to deduct, in computing their income for tax purposes, the amounts paid on account of the interest owing on the MKH loan. [2]

The Minister of National Revenue in reassessing the taxes payable by them disallowed the deduction of these amounts which they claimed.

Judgments

(a) Tax Review Board

In stating the issue as to whether or not MerBan could claim the amount of $405,000 as interest expense such that its non-capital loss for the taxation year in question would be $627,457 (or $222,457, if the claim were disallowed), the Chairman of the Tax Review Board concluded:

The evidence established that all concerned, including the Toronto Dominion Bank, accepted that M.K.H., Merban-Kaps Holdings Limited and Merban were in fact the same interest group all of whom, albeit indirectly in some instances stood to benefit from the acquisition of Kaps Transport Limited and all were willing to pay the interest on the loan which made the acquisition possible and which was reflected in the wording of the loan agreement, not as a guarantee payment, but as a direct liability.

I must conclude that the payment made in the 1974 taxation year by the appellant Merban of $405,000.00 as interest due on the loan of $2,250,000.00, was a deductible expense, as were the payments made by the appellant’s Carter and Montague (who had a beneficial interest in Casamont Trust) for the taxation years 1973 and 1974. . . . [3]

(b) Federal Court-Trial Division

The Minister appealed the decision of the Tax Review Board to the Federal Court—Trial Division. In his judgment dismissing the appeal, the trial judge made the following findings on the evidence:

(1) I find that the whole venture was MerBan's, that Merban's [sic] risk was exclusive and that MerBan alone stood to gain or lose from it;

(2) As corollary, I find that the intervening companies namely MKH Investments Ltd. and MerBan-Kaps Holdings Ltd., could neither profit nor lose from their participation. They may be called paper companies created for a single and individual purpose. Once that purpose had been achieved, they were functus, They [sic] were clones of MerBan and nothing more.

(3) I find that the creation of the intermediate companies was for technical purposes and to satisfy the requirements of both parties. As the memorandum of September 28,1972 clearly indicates, the Bank had to find some justification for its participation along the lines of the proposal made to it by MerBan. The Bank through its equity group wanted an option on future participation in Kaps shares. It was also keenly interested in securing Kaps banking business and it relied on MerBan's representation to it in this respect. The deal between the parties was a quid pro quo and without being able to distinguish between the quid and the quo, there was mutual agreement that providing every block in the financing deal was in place, the Bank was prepared to waive recourse against MerBan and limit liability for the loan interest to the sum of $500,000.

(4) I find that the Bank could not conceivably look to either of the intervening companies for any interest payments. Apart from the possibility of dividend payments to Holdings from Kaps, the two companies had no operations which might have generated income to service the debt nor did they have any assets which had not already been pledged directly or indirectly to the Bank and which the Bank could have seized in satisfaction.

(5) I find on the evidence that there was never any pretense on the part of the parties involved to look otherwise on the intervening companies as being essentially artificialities. The charging and collecting of outstanding interest by the Bank were from MerBan and MerBan alone. The process, which as I understood it, was a call by the Bank to MerBan to pay overdraft in the intermediary's account which overdraft had been incurred by a bank entry representing an interest payout to the Bank, was itself artificial and constituted mere bookkeeping entries bereft of any substance.

(6) I find that the technical arrangements which were made were not for the exclusive benefit of MerBan. I find that:

(a) the importance of the non-recourse feature on the bank loan must be limited, in my view, by the realities of the situation then existing. The evidence is clear that the Bank enjoyed excellent coverage on its accommodation. Furthermore, under the terms of the hypothecation instrument the Bank could sell the Kaps shares "without notice whenever it should think proper to do so." Further, the Bank did sell the shares when their value dropped to $7.50, a level where MerBan's equity of $1,250,000 had been effectively consumed.

(b) the limitation on loan interest of $500,000 must also be viewed with the same sense of the realities. The loan agreement was for a relatively short-term of thirty months. At the rate charged by the Bank, at that time, the commitment by MerBan amounted to some 18 months of interest payment. [4]

The trial judge concluded that MerBan's obligation to the Bank was not one of guarantee, the essence of which involved a contingent liability which is triggered on the prime debtor's default; but rather that MerBan was a prime obligor. [5] The trial judge then went on to discuss a number of authorities dealing with the deductibility of interest [6] and re-emphasized the “one on one" relationship between the Bank and MerBan, notwithstanding the arrangements involving intermediate subsidiaries. He then concluded:

Having made the foregoing findings, I need not engage in a detailed analysis as to whether the amount paid by MerBan to the Bank is deductible under Section 18 or Section 20 of the Income Tax Act. Whether that payment is categorized as interest in the true sense, or a cost of doing business, or a flat-rate charge, or rent for the lease of the Bank's money, the amount constitutes an allowable deduction. [7]

Legislation

The major sections of the Income Tax Act [8] (the "Act") which are germane to this appeal are the following:

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

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

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

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),

(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), or

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

(e) an expense incurred in the year,

(i) in the course of issuing or selling shares of the capital stock of the taxpayer, or

(ii) in the course of borrowing money used by the taxpayer for the purpose of earning income from a business or property (other than money used by the taxpayer for the purpose of acquiring property the income from which would be exempt),

but not including any amount in respect of

(iii) a commission or bonus paid or payable to a person to whom the shares were issued or sold or from whom the money was borrowed, or for or on account of services rendered by a person as a salesman, agent or dealer in securities in the course of issuing or selling the shares or borrowing the money, or

(iv) an amount paid or payable as or on account of the principal amount of the indebtedness incurred in the course of borrowing the money, or as or on account of interest;

Issues

Although the major issue in this appeal centres on the deductibility for income tax purposes of the amounts paid by MerBan on the loan from the Bank to MKH pursuant to the deficiency agreement, that issue in turn raises the following questions:

1. Whether the learned trial judge erred in ignoring the separate existence of MerBan from its subsidiaries, MKH and Holdings, in the transactions undertaken by them?

2. Whether the trial judge erred in holding that the disputed payments were incurred for a business purpose and that he did not have to determine which section of the Act permitted the deduction of the amounts?

3. Apart from the holding of the trial judge, were the disputed payments nonetheless deductible under:

(1) paragraph 18(1)(a) of the Act and not prohibited under paragraph 18(1)(b) of the Act; or under

(2) paragraph 20(1)(c) or 20(1)(e) of the Act?

For reasons that follow, I respectfully disagree with the decision of the trial judge and would allow the appeal with costs. I should like to discuss each of the above-stated issues in turn.

Separate Existence

The issue of separate existence of MerBan from its subsidiaries is important because of the basic rule that a taxpayer can deduct only expenses that it incurred to earn its income. If, as counsel for the Minister contends, MerBan is to be treated as a separate legal entity from its subsidiaries, then MerBan has considerable difficulty in arguing that the payment to the Bank was incurred to earn MerBan's income because the source of the income — primarily dividends to be paid on the Kaps shares held by Holdings — was that of its subsidiary, Holdings. Moreover, if the separate existence of the corporations is recognized, then it is also more difficult, as will be discussed later, for MerBan to maintain it can deduct the payments made to the Bank under paragraph 20(1)(c) of the Act because the payments to the Bank were not interest in respect of indebtedness incurred by MerBan in that the money borrowed was effected by MKH not by MerBan.

I do not agree that the separate existence of the parent and subsidiary corporations involved in this matter should be disregarded. In my view, each of the corporations: MerBan, MKH, Holdings, played specific roles and for income tax purposes were not "clones" or "artificialities" as described by the trial judge. MerBan was no doubt the driving force behind and ultimate beneficiary of the subsidiaries’ activities, restricted as they were. It may be that the trial judge believed that the subsidiaries as mere instrumentalities served no business purpose. But it has been held that, even when there is a lack of business purpose, courts will recognize otherwise legally valid and complete transactions [9] or legally created relationships which are clearly enforceable. [10] In this case, MerBan wanted to limit its liability and to employ the financing device of an income debenture and accordingly used two subsidiaries to accomplish these specific, highly important and legitimate purposes. Accordingly, I do not see why the separate legal existence should be ignored when matters have not turned out as the parties may have intended such that MerBan is entitled in effect to treat itself and its subsidiaries as one entity for tax purposes. There was no "sham", "agency" or "nominee" relationship as has been interpreted by the cases [11] for a court to conclude in the case at bar that separate corporate existence should be disregarded. Consequently, the normal rule of a corporation being a separate and distinct legal entity from its shareholders applies. [12]

I should add that counsel for the respondents argued that the finding of the trial judge on ignoring the separate existence of the corporations is one that should not be disturbed by an appellate court. However, even assuming that the finding is one of fact or inference from fact, it is not one which precludes this Court from overturning it. In this connection, I adopt what Urie, J.A. said in The Queen v. Gurd's Products Company Limited: [13]

The first question for this Court, then, must be whether or not an intermediate appellate court ought to disturb this finding. The short answer to that question, as I see it, is that if this is a proper case the Court may do so. What is a proper case? In Bemax [sic] v. Austin Motor Co, Ltd, 1 All ER 326 at 329, it was said that "Where the point in dispute is the proper inference to be drawn from proved facts" and where there is no question of the credibility or reliability of any witness, as here, an appeal court is in as good a position to evaluate the evidence as the trial judge "and ought not to shrink from that task, though it ought, of course, to give weight to his opinion.

This view of the role of an appellate court was affirmed by the Supreme Court of Canada in Lessard v. Paquin et al, [1975] 1 SCR 665 at 675. Since neither of the parties dispute the findings of fact made by the trial judge, I have no difficulty in concluding that this Court is entitled to disagree with the trial judge on the inferences to be drawn from such facts if the Court is of the opinion that these inferences cannot, in the circumstances, be supported. [14]

I am of the opinion that the inferences drawn by the trial judge on the question of separate existence cannot be supported.

Deductibility of Disputed Payments

(1) General Principles

As noted, the trial judge held that the disputed payments were incurred for a business purpose and that he need not specify whether a deduction was permissible under either section 18 or 20 of the Act. With respect, I do not agree with that approach.

The scheme of the Act relating to allowable deductions puts considerable emphasis on the nature of the deductions and, in my view, it is most important to specify quite clearly the statutory basis of a proposed deduction.

Subject to the statutory qualifications and exceptions in the Act, an expense to be currently deductible from business or property income must:

1. be deductible in computing “profit” in accordance with ordinary commercial practice;

2. have been incurred for the purpose of earning income;

3. be reasonable in amount; and

4. not be

(i) a “capital outlay" or “capital expenditure", viz, not incurred to acquire a long-term asset or advantage;

(ii) artificial in nature;

(iii) a personal expenditure;

(iv) otherwise expressly prohibited by the Act. [15]

Thus the payments made by MerBan might well be deductible under (1), (2) and (3) above, but be disqualified from deductibility under an item in (4) above. In other words and as will be discussed below, the payments may have been made for the purpose of earning income (paragraph 18(1)(a)) but if they could be characterized as capital outlays (paragraph 18(1)(b)) they would be non-deductible. All this is to say that I believe it is very important to specify the provisions of the Act pursuant to which a deduction can be made.

However, these comments do not dispose of the matter because it must be determined whether MerBan is entitled to claim a deduction by reference to a specific provision of the Act. In this respect, the major sections of the Act applicable to the facts are sections 18 and 20 to which I now turn.

(2) Section 18

At the outset, I believe it worthwhile to comment on the nature of paragraph 18(1)(a) of the Act upon which counsel for the respondents placed great emphasis in argument. Paragraph 18(1)(a) is not, as counsel for the respondents appeared to argue, a provision which entitles a taxpayer to deduct an amount paid. Rather paragraph 18(1)(a), expressed in negative terms, limits the right to claim deductions; it does not authorize the right to deduct an amount since, as has been pointed out, such right must be found elsewhere in the Act. [16] Paragraph 18(1)(a) is one of the hurdles that an outlay has to go through to enjoy the status of deductibility under the Act; the paragraph does not confer the status of deductibility if its test is met.

In that connection, counsel for the Minister did not argue very strongly that the payments of MerBan did not meet the test of paragraph 18(1)(a). Counsel did argue that paragraph 18(1)(a) of the Act requires an outlay to be incurred for the purpose of gaining or producing income from its business and MerBan's payments to the Bank were made to enable a subsidiary, Holdings, to acquire property (the Kaps shares) to enable Holdings, in turn, to earn income. Consequently, a payment made to allow a subsidiary to earn income is a payment made in respect of another taxpayer's business and arguably does not meet the requirements of paragraph 18(1)(a). On the other hand, it should be noted that paragraph 18(1)(a) speaks of an outlay or expense incurred for the purpose of gaining or producing income from the business or property. MerBan's property in this connection was its shares in MKH, and through MKH, its shares in Holdings. So MerBan's payments to the Bank were arguably made for the purpose of gaining income through the eventual flow-through to MerBan of dividends on the Kaps shares owned by Holdings. [17]

However, I do not find it necessary to comment further on whether the requirements of paragraph 18(1)(a) are met because even if they are, I am of the view that the MerBan payments come within the provisions of paragraph 18(1)(b) as capital outlays or expenditures and are therefore not deductible.

There was much argument before us as to the nature of the undertaking which gave rise to the payments made by MerBan. Counsel for the Minister, pointing to the terminology used in the agreement [18] and authority, [19] argued that the so-called deficiency agreement amounted to a guarantee by MerBan of the interest owing by MKH on its loan from the Bank. As a guarantee, it was in the nature of a capital outlay and therefore not deductible by operation of paragraph 18(1)(b) of the Act. [20] In the alternative, counsel for the Minister argued that, even if the undertaking were not one of guarantee but an agreement of indemnity, it was nonetheless still of a capital nature and prohibited by paragraph 18(1)(b).

On the other hand, counsel for the respondents argued that MerBan's undertaking in the deficiency agreement made it a prime obligor and this was the conclusion arrived at by the trial judge who said the obligation of MerBan was direct and not contingent as is the case with guarantees.

Admittedly, the language used by the parties in the deficiency agreement is ambiguous as to whether the undertaking amounted to a guarantee. [21] But whether the undertaking is a guarantee or indemnity or even a hybrid, I am of the opinion that in any case the amounts paid were capital in nature.

The classic statement of the capital expenditure or outlay rule was given by Viscount Cave, L.C. in British Insulated & Helsby Cables Ltd. v. Atherton: [22]

But when an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think there is very good reason . . . for treating such an expenditure as properly attributable not to revenue but to capital. [23]

Here the payments made by the MerBan Group were originally treated by MKH in its financial statements as loans made to it by its shareholders. It seems to me that such treatment accorded with their income tax character, namely, they were payments to enable subsidiaries MKH and Holdings to make related loans and investments — in this context assets or advantages for an enduring benefit — and so represented costs of financing such subsidiaries which in a number of cases have been held to be capital in nature. [24]

Accordingly, the respondents are prohibited from deducting their payments to the Bank under the provisions of paragraph 18(1)(b). However, this now takes us to section 20 because if the respondents can come within that section they will be successful since the terms of the introductory language of section 20 expressly override the prohibitions stipulated in paragraphs 18(1)(a) and (b).

(3) Section 20

Under subparagraph 20(1)(c)(i) of the Act, a taxpayer may deduct, with respect to business or property income, an amount paid pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from a business or property. Counsel for the respondents argues that the payments made by MerBan come within these provisions whereas counsel for the Minister contends they do not.

As was Said by Chief Justice Dickson in The Queen v. Bronfman, in the absence of a provision like paragraph 20(1)(c) of the Act, interest payments could not be deductible as they would fall within payments on account of capital within the prohibition language of paragraph 18(1)(b) discussed above. [25] But there are several requirements to be met before interest may be deducted by a taxpayer pursuant to paragraph 20(1)(c). In general terms,

(i) the interest must be paid or payable pursuant to a legal obligation with respect to borrowed money;

(ii) the borrowed money must be used for the purpose of gaining income from a business or property; and

(iii) the borrowed money cannot be used for property, the income from which would be exempt or to acquire a life insurance policy.

What is fatal to the respondents' case in my view is that paragraph 20(1)(c) requires that for interest to be deductible it must be paid pursuant to money borrowed by the taxpayer and not by someone else. The taxpayer must have created a borrower-lender relationship which gives rise to interest being paid.

I conclude this from the wording of section 20 which in subsection 20(1) speaks of the taxpayer's income from a business or property and there being deducted from these sources certain amounts of which interest on borrowed money is one. If the taxpayer is calculating income from a source, it flies in the face of the intent and language of the Act to allow the taxpayer to deduct interest with respect to the income source of another taxpayer. [26] In the instant case, MerBan was not obligated to pay anything in respect of the principal of the loan. The Bank, apart from collateral undertakings, could look only to MKH and Holdings for payment on the loans and income debenture and to the MerBan Group for up to $500,000 for interest on the loan. To say that MerBan can deduct the payments as interest would mean that MerBan was the borrower of the money from the Bank, which it was not. Accordingly, I conclude that the payments made by MerBan do not qualify as interest deductions under the provisions of paragraph 20(1)(c) of the Act. [27]

Counsel for the respondents also argued in the alternative that the payments made by MerBan were deductible under subparagraph 20(1)(e)(ii) as an expense incurred in the course of borrowing money used by the taxpayer for the purpose of earning income from a business or property. However, again fundamentally important to the availability of this deduction is that the taxpayer borrow the money to which the expense relates. As already mentioned, MerBan did not borrow any money from the Bank, its subsidiaries MKH and Holdings did, and therefore a deduction under subparagraph 20(1)(e)(ii) is not available to MerBan.

Conclusion

For the foregoing reasons, I would allow the appeal with costs here and in the Federal Court—Trial Division, set aside the judgment of the Trial Division and restore the reassessments of tax issued by the Minister for the 1974 taxation year of MerBan and for the 1973 and 1974 taxation years of Montague and Carter.

Appeal allowed.