Kalthoff v. The Queen, 90 DTC 6378, [1990] 1 CTC 336 (FCTD), aff'd 92 DTC 6001 (FCA)

Martin, J.:—The plaintiff is a farmer who now resides in the City of Saskatoon. Not only was the plaintiff a farmer but he was also a successful one who had, by 1980, accumulated substantial savings, property and credit. In that year he decided to invest in Saskatoon real estate. His intention was to acquire some vacant land and, probably within a year or two years at the most, to construct a building and lease space comprising a mix of office and retail space.

With that in mind he entered into two agreements to purchase lands in the Block 3 area of Saskatoon. The first agreement dated March 26, 1980 related to the acquisition of lots 4, 5 and 6 from Alpha Contracting Ltd. for $525,000, the final payment of $425,000 under which was

. . . to be paid to the Vendor on or before the 1st day of August, A.D. 1980, plus interest at the rate of 15% from April 1, 1980, to date of payment, it being understood and agreed that should the final payment of $425,000.00 not be paid on the 1st day of August, A.D. 1980, that the said amount overdue shall bear interest at prime rate charged by Bank of Montreal, Saskatoon, plus 4% from the 1st day of August, A.D. 1980 to the date of payment,

The second agreement, dated May 1980, related to the acquisition of lot 7 from O & W Developments Ltd. for $272,000. The final payment of $202,000 was to be paid on or before the 1st day of July, 1980 upon which there would be

. . . interest on the said sum of Two Hundred and Two Thousand Dollars ($202,000.00) or so much thereof as shall from time to time remain unpaid from the 10th day of May, 1980 at a rate of interest of Thirteen Percent (13%).

The plaintiff paid substantial amounts down on each of the agreements and engaged Norsask Realty Ltd. to find a source of mortgage funds to finance the balance of $590,000 which he required, in addition to the amount of his own money he was prepared to put into the project, for the purchase of the properties. Norsask introduced him to the Canadian Commercial and Industrial Bank ("C.C.I.B.") and in return for doing so charged him a mortgage finder's fee of $5,900.

On May 20, 1980, C.C.I.B. issued a letter of commitment to the plaintiff under the terms of which it agreed to advance $390,000 (subsequently increased to $590,000) on a short-term, one year, basis. For this commitment C.C.I.B. charged the plaintiff a fee of $5,900.

Although the plaintiff's intention had been to borrow the money personally and to develop the lands in a partnership arrangement with one Schwartz, C.C.I.B. would not accept this arrangement. Instead it insisted, and made it a condition of its commitment, that the borrower be a limited liability company, the shares of which would be owned by the plaintiff and his wife and which company would in turn own the properties which the plaintiff had intended to acquire.

It was also a condition of C.C.I.B.'s commitment that the company would provide the bank with a first and floating mortgage debenture charge over the properties in question and any other assets of the company. C.C.I.B. also required personal guarantees of the plaintiff and his wife for the full amount of the loan to the company and an agreement from the plaintiff to enter into a collateral mortgage of his farm property as security for the company's indebtedness to the extent of $200,000, if required by C.C.I.B,

Following receipt of this letter the plaintiff caused a company, Kal-A Investments Ltd. ("Kal-A"), to be incorporated on June 24, 1980, Some of the subsequent real estate transaction dates do not appear to be absolutely precise from the evidence but, within a few days accuracy, the following transactions occurred:

1. On or before July 1, 1980, Kal-A became the owner of lot 7,

2. On or before August 1, 1980, Kal-A became the owner of lots 4, 5 and 6.

3. By a Mortgage Debenture dated July 30, 1980 and registered in the Saskatchewan Land Titles Office, Kal-A charged lots 4, 5, 6 and 7 to secure the repayment of the sum of $590,000 which it borrowed from C.C.I.B.

4. By a Collateral Mortgage dated July 30, 1980, the plaintiff charged in favour of C.C.I.B. certain of his personal lands to the extent of $200,000 as collateral security for the repayment of $590,000 borrowed by Kal-A.

In addition to these documents, on July 2, 1980 the plaintiff and his wife executed in favour of C.C.I.B. unlimited guarantees for the repayment to C.C.I.B. of all moneys-borrowed by Kal-A.

For the plaintiff's taxation years 1980 to 1983 inclusive the plaintiff claimed under the Income Tax Act sections noted and was disallowed the following expenses which he appeals in the four causes now before me:

I should note here that paragraph 7(a) of the amended statement of claim filed on February 6, 1990 claimed as a deduction against the plaintiff's taxable income $2,510.13 paid as legal fees but, on the motion to file the amended statement of claim, this amount was withdrawn and deleted from the plaintiff's claim.

It is not disputed by the Crown that the plaintiff did in fact pay the moneys which he claims to have paid. The evidence disclosed that some of the interest payments on the debenture from Kal-A to C.C.I.B. had been made by Kal-A but the evidence showed that these payments had been made in error and once discovered adjustments were immediately made so that Kal-A was reimbursed by the plaintiff for the amounts of those payments.

The Crown's position with respect to the three types of amounts claimed as deductions by the plaintiff against his taxable income is as follows:

(a) interest on the debenture from Kal-A to C.C.I.B. cannot be deducted pursuant to subparagraph 20(1)(c)(i) of the Income Tax Act because Kal-A and not the plaintiff is the borrower of the $590,000 loan under the debenture;

(b) interest on the amounts payable under the agreements between the plaintiff and Alpha Contracting Ltd. and O & W Developments Ltd. respectively, if claimable at all under subparagraph 20(1)(c)(ii), can only be claimed as deductions from the dates of the respective agreements until May 20, 1980, the date on which the plaintiff first became aware that the development of the properties in question would have to be by a company and not by him personally;

(c) mortgage finder's and commitment fees would fall within subparagraph 20(1)(c)(ii) if the services requested by the plaintiff for which the fees were charged were requested prior to May 20, 1980, being the time that the plaintiff was informed by C.C.I.B. that the borrower would have to be a limited liability company rather than the plaintiff personally. In this respect I note that the plaintiff does not claim to be entitled to deduct the amounts represented by these fees under the provisions of subparagraph 20(1)(c)(ii) but rather under subparagraph 20(1)(e)(ii).

In my view the plaintiff is not entitled under subparagraph 20(1)(c)(i) to claim as deductions against his taxable income the amounts paid in respect of interest under the terms of the debenture mortgage between Kal-A and C.C.I.B. because Kal-A and not the plaintiff was the borrower of the $590,000 under the terms of that debenture.

Counsel for the plaintiff and the plaintiff's witnesses were at pains to attempt to show that the plaintiff was obliged to pay the interest under a verbal agreement between himself and one Schwartz, between himself and Kal-A and under the terms of the collateral mortgage between himself and C.C.I.B. His accountant, Mr. Michael L. Deutscher, a chartered accountant, noted that the financial statements of Kal-A did not indicate any debt obligation from Kal-A to C.C.I.B. while the personal statements of the plaintiff showed the debt to be that of the plaintiff personally.

Mr. Wayne N. Martinson, a former manager of the Saskatoon Branch of C.C.I.B., acknowledged that C.C.I.B. was looking to the plaintiff for the payment of the mortgage interest and not to Kal-A because Kal-A had no revenue and was not expected to have any until at least a year after the $590,000 had been loaned to Kal-A.

Finally counsel for the plaintiff, in the pleadings, submits that it was the intention of the plaintiff throughout to borrow money personally to finance the purchase of the properties and to earn income from either business or property from that borrowed money and, because the plaintiff carried out that intent, the interest paid on the borrowed money should be properly deductible under subparagraph 20(1)(c)(i).

The same argument was raised in The Queen v. MerBan Capital Corporation Limited, [1989] 2 C.T.C. 246; 89 D.T.C. 5404, and rejected by the Chief Justice of this Court at pages 258-59 (D.T.C. 5413) where he found that:

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.

In my view the same reasoning is fatal to the plaintiff's claim in this case. He was the guarantor of the repayment of the amount borrowed by Kal-A. He had given collateral security for the amount borrowed by Kal-A and, as between himself and Kal-A and his co-shareholder Schwartz, he may well have had a legal obligation to pay the interest to C.C.I.B. Notwithstanding all of that, however, it was Kal-A and not the plaintiff which borrowed the $590,000 so that the interest on that amount, even though paid by the plaintiff, was not paid on money which the plaintiff borrowed but on money which was borrowed by someone else. It follows, at least from my reading of the MerBan decision, that the plaintiff is not, therefore, entitled to deduct from his taxable income the amounts of interest thus paid.

The same argument must prevail with respect to the mortgage commitment and finder's fees of $5,900 each. Counsel for the Crown indicated that they might qualify as deductions under the provisions of subparagraph 20(1)(c)(ii), being interest on amounts payable for property acquired for the purpose of producing income, if the services in respect of which the amounts were paid were required prior to the time that the plaintiff became aware that C.C.I.B. would not lend money to him personally.

In my view subparagraph 20(1)(c)(ii) does not apply to the amounts represented by the finder’s and mortgage commitment fees paid by the plaintiff to Norsask and C.C.I.B. because these amounts were not interest on amounts payable for property. They were fees or expenses for services rendered which were calculated by reference to a percentage of the amount which was to be loaned. Being fees for services rendered they cannot be claimed as interest on amounts payable for the property acquired.

As already indicated the plaintiff did not claim these amounts as deductions under subparagraph 20(1)(c)(ii) but as expenses incurred in the course of borrowing money used by him for the purpose of earning income from a business or property under the provisions of subparagraph 20(1)(e)(ii). Unfortunately the same reasoning applies in respect of these amounts as to the deductions of interest paid by the plaintiff under the Kal-A debenture to C.C.I.B. The Chief Justice in the MerBan decision, supra, dealt with a similar claim in the following terms at page 259 (D.T.C. 5413):

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.

The fact here, as in MerBan, is that the plaintiff did not borrow the $590,000 from C.C.I.B. and thus he may not deduct the finder's and commitment fees associated with the loan as an expense incurred in the course of borrowing that money. The fact the plaintiff's accountant chose not to show the $590,000 as a liability in the books of Kal-A, the fact that C.C.I.B. looked to the plaintiff and not to Kal-A for repayment and the fact that the plaintiff intended to borrow the money are all irrelevant. Kal-A was the borrower not the plaintiff and for that reason the plaintiff is not entitled to claim the interest on the loan or the expenses incurred in the course of making the loan as deductions against his taxable income.

Counsel for the Crown has admitted the entitlement of the plaintiff to deductions of interest on amounts payable for the properties which the plaintiff originally intended to purchase but says the deductions must be limited to interest calculated from the dates of the agreements until May 20, 1980 at which time C.C.I.B. informed the plaintiff that it would lend the balance required for the purchase price of the properties only to a company and not to the plaintiff personally.

I accept counsel's reasoning that subparagraph 20(1)(c)(ii) does not require that money be borrowed, as does subparagraph 20(1)(c)(i), but enables a taxpayer to claim as deductions against his taxable income amounts paid as interest on amounts payable for properties being acquired in the circumstances of this case. It is therefore common ground that the plaintiff may claim as deductions against his taxable income the interest on the $202,000 and the $425,000 payable in respect of the properties which the plaintiff intended to acquire for a purpose which admittedly (as I understand the position of counsel for the Crown) falls within subparagraph 20(1)(c)(ii).

The only question with respect to these sums is the period during which the interest may be claimed i.e. at what dates can the interest be said to commence and at what dates should the interest paid be disallowed. With respect to the dates of the commencement of the interest I can see no logic behind counsel's suggestion that interest run from the dates of the agreements. The agreement of March 26, 1980 provided that interest would commence on April 1, 1980. Because no interest was payable or paid in respect of the period from March 26, 1980 to April 1, 1980 there is no basis on which interest could be allowed for that period.

The agreement of May 1980 relating to lot 7 is undated, except as to its being executed in the month of May. It does provide that interest on the $202,000 begins to run on May 10, 1980. In my view this would be the appropriate date from which interest should begin to run and was in fact the date from which interest was calculated and paid.

I cannot understand the reasoning behind the suggestion that the interest claimed under subparagraph 20(1)(c)(ii) should cease to run after the date, May 20, 1980, on which the plaintiff was informed that C.C.I.B. was only prepared to make a loan to a company owned by him and not to him personally.

It is true that, as of that date, the plaintiff was aware of C.C.I.B.'s position but until such time as the plaintiff committed himself to accepting the condition set by C.C.I.B. it was open to him to seek a different borrower who might be prepared to lend the amount required to the plaintiff personally. There is evidence that C.C.I.B. sought commitments from the plaintiff as of July 2, 1980 but there is no evidence of the date on which the plaintiff unreservedly gave those commitments.

On the evidence before me it was open to the plaintiff to cause his company to withdraw from the C.C.I.B. proposal at any time prior to the execution of the mortgage debenture on July 30, 1980 and accordingly I can see no reason why interest amounts calculated respectively from April 1, 1980 and May 10, 1980 up to as late as July 30, 1980 should not be allowed as deductions under the provisions of subparagraph 20(1)(c)(ii).

For the foregoing reasons judgment will be given dismissing the plaintiff's appeals against the reassessments for interest paid on the C.C.I.B. debenture and the mortgage finding and commitment fees. Judgment will also be given allowing the plaintiff's claims for interest actually paid on amounts payable under the purchase agreements relating to lot 7 and lots 4, 5 and 6 from the dates on which interest began to run under the terms of each of those agreements to and including July 30, 1980 or the date on which interest ceased to be paid, whichever is the earlier.

In general the defendant has been successful in these proceedings but at the same time the plaintiff has, in a lesser way, also been successful. In my view this is not a case for awarding full costs to the generally successful party. In the circumstances of the present case the defendant will have eighty per cent (80%) of her taxed costs.

Pursuant to paragraph 337(2)(b) of the Federal Court Rules, counsel for the defendant is directed to prepare a draft of the formal judgment and to submit the same to counsel for the plaintiff for approval as to its form and then to me for review and, if accepted, for entry.

Appeal allowed in part.