Her Majesty the Queen v. Said Mohammed Attaie, [1990] 2 CTC 157

Desjardins, J.A.:—This is an appeal from a decision of the Trial Division whereby Collier, J. concluded that interest amounts paid on borrowed money used to purchase a family dwelling were deductible from the taxpayer's income for the taxation years 1980, 1981, 1982 pursuant to subparagraph 20(1)(c)(i) of the Income Tax Act! [1] ("the Act").

The facts are not in dispute.

The respondent, a native of Iran, is married with two children. He first came to Canada without his family in 1978. He then decided to move himself and his family permanently to Canada. He looked for a house. In October 1978, he entered into an agreement to buy a home in the Don Mills area of Toronto. The closing date was December 29, 1978. The purchase price was $105,000. The respondent at that time had $60,000 in funds. He signed a mortgage agreement in order to borrow $54,000. It was a fully open mortgage, repayable at any time, maturing November 30, 1983. The respondent insisted on those terms, at the cost of paying further interest and against the advice of his real estate agent, in view of the fact that he had approximately $200,000 in funds in Iran. He expected to move such moneys out of that country within a matter of months and was anxious to repay the mortgage loan without notice or bonus.

He returned to Canada in 1979. The home in Don Mills was rented until the end of May 1980. For those first five months of 1980, the defendant reported rental income in his tax return. He deducted expenses in respect of the property including the interest paid pursuant to the mortgage. The interest expense was allowed by the revenue department.

From June 1, 1980, the respondent and his family occupied the home as the principal residence. The $200,000 in funds from Iran arrived in this country in May or June 1979. At this time the interest rate on term deposit investments was substantially higher than the mortgage interest the respondent was paying on the loan. He decided not to pay off the mortgage but invested the $200,000 instead. He did so until February 1983 when, on account of a decrease in the interest rate on term deposits, he paid off the mortgage loan.

In his 1980, 1981 and 1982 income tax returns, the respondent declared the interest received from the term deposits as income. He sought to deduct the interest amounts paid on the borrowed mortgage funds. The amounts claimed were:

The Minister disallowed those deductions.

The trial judge allowed the deductions, thus confirming the Tax Court (Said M. Attaie v. M.N.R. [1985] 2 C.T.C. 2331; 85 D.T.C. 613 (T.C.C.); affd [1987] 2 C. T.C. 212; 87 D.T.C. 5411 (F.C.T.D.)). [2] He stated that according to the decision of the Supreme Court of Canada in The Queen v. Bronfman Trust, [1987] 1 S.C.R. 32; [1987] 1 C.T.C. 117; 87 D.T.C. 5059 it was not the purpose of the borrowing which was relevant: it was the taxpayer's purpose in using the borrowed money: the current use, not the original use, was relevant. Then he said at page 216 (D.T.C. 5414):

Here, the defendant's original purpose was to obtain funds to complete the purchase of the home. Once he received the funds from Iran that use of the borrowed funds, in a practical business sense, ceased. He made a carefully thought-out decision to maintain the borrowing in order to invest in attractive term deposits and earn income. This was done with an eye to the practical commercial and economic realities at the time.

In his view, the respondent was then in the same situation as that found in the case of B.B.P Sinha v. M.N.R., [1981] C.T.C. 2599; 81 D.T.C. 465 referred to by Dickson, C.J. in Bronfman Trust, supra, where, with regard to B.B.P. Sinha, Dickson, C.J. said at page 125 (S.C.R. 47; D.T.C. 5065):

Conversely, a taxpayer who uses or intends to use borrowed money for an ineligible purpose, but later uses the funds to earn non-exempt income from a business or property, ought not to be deprived of the deduction for the current, eligible use: Sinha v. M.N.R., [1981] C.T.C. 2599; 81 D.T.C. 465 (T.R.B.); Attaie v. M.N.R., [1985] 2 C.T.C. 2331; 85 D.T.C. 613 (T.C.C.) (presently under appeal). For example, if a taxpayer borrows to buy personal property which he or she subsequently sells, the interest payments will become prospectively deductible if the proceeds of sales are used to purchase eligible income-earning property.

The trial judge concluded at page 217 (D.T.C. 5415):

The Sinha decision was not appealed. I note the factual pattern there was quite similar to the factual pattern here. The Supreme Court, in that passage, made no adverse remarks about those two decisions.

This defendant has, in my view, brought himself within the converse proposition set out by the Chief Justice.

The appellant's position is that the borrowed moneys were used by the respondent to purchase a property which served as the respondent's personal residence during the taxation years 1980, 1981 and 1982. It was an error, both in fact and in law, for the trial judge to find that such use ceased when the respondent invested other funds in income-earning deposits. Once the property became occupied as a personal residence, it could not be found that the direct and actual use of the borrowed moneys was for the purpose of earning moneys from a business or property. It should not, therefore, have been held that the interest on the mortgage was deductible under the provisions of subparagraph 20(1)(c)(i) of the Act.

The respondent's position is that at all relevant times the borrowed funds were used, as found by the trial judge, for the bona fide purpose of producing income. The respondent taxpayer finds himself in the exceptional circumstances described by Dickson, C.J. in Bronfman Trust. Despite the fact that the borrowed funds were originally used to purchase a residence which was subsequently occupied by the taxpayer, the interest rate which the taxpayer was able to obtain in the invested fund exceeded, at all times, the interest rate payable on the mortgage. The borrowed funds involved the production of income in a situation where no other arrangement of financing could produce the same high rate of profit with consequent greater net tax liability. Had the taxpayer retired the mortgage immediately upon the receipt of the funds from Iran, and then subsequently obtained a new mortgage to allow for the making of investments, both the income which he would have produced and the net tax liability would have been far less than the respective income generated and the tax payable as a result of his efforts to augment his income earning potential. This, he submits, meets the intent Parliament had in adopting subparagraph 20(1)(c)(i) of the Act. Unlike Bronfman Trust, the taxpayer here can point to a reasonable expectation that the income yield in investment of the funds received from Iran would exceed the interest payable on the like amount of debt. To deny the deductibility of interest in favour of a non- beneficial requirement of form is to discourage the accumulation of capital producing taxable income contrary to the legislative intent. The commercial and economic reality makes it appropriate to allow the taxpayer to deduct the interest on the funds notwithstanding that they were not originally borrowed for the purpose of gaining or producing income.

I agree with the appellant's position.

The relevant parts of subparagraph 20(1)(c)(i) read at the relevant time thus:

20(1) Deductions permitted in computing income from business or property.— 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), . . .

The purpose Parliament had in mind in adopting such provisos was assessed by Dickson, C.J. in Bronfman Trust in the following terms at page 124 (S.C.R. 45; D.T.C. 5064):

I agree with Marceau, J. as to the purpose of the interest deduction provision. Parliament created subparagraph 20(1)(c)(i), and made it operate notwithstanding paragraph 18(1)(b), in order to encourage the accumulation of capital which would produce taxable income.

According to Bronfman Trust, the statutory provisions require that the inquiry to be made, be centred on the use to which the taxpayer put the borrowed funds. Their current use rather than their original use is relevant in assessing deductibility of interest payments.

It is not disputed that the interest payments on the mortgage were correctly deducted from the revenue earned for the period of time the respondent's house was used as a rental property. Once the house ceased to be a rental property, interest paid on the mortgage was no longer deductible since the income producing property aspect of the house ceased to exist. The current use of the moneys became a non-eligible use. The fact that the respondent decided to maintain the borrowing and use the funds received from Iran to make a more profitable investment, does not render the interest paid on borrowing "interest on borrowed money used for the purpose of earning income from a business or property" as these words are found in subparagraph 20(1)(c)(i) of the Act. In Bronfman Trust, Dickson, C.J. said at page 127 (S.C.R. 50; D.T.C. 5066): ”. . .it has been held repeatedly that an individual cannot deduct interest paid on the mortgage of a personal residence even though he or she claims that the borrowing avoided the need to sell incomeproducing investments."

The same applies although what was contemplated here was not borrowing so as to prevent a sale of assets like in Bronfman Trust but borrowing for the use of a personal residence so as to retain personal funds for use as an incomeproducing investment. The borrowed funds are not related directly to the income-producing investment so as to make the costs of the borrowing related to the income produced. (See Emerson v. The Queen, [1986] 1 C.T.C. 422; 86 D.T.C. 6184 (F.C.A.).)

The indirect use of the borrowed funds does not make this deduction possible. In Bronfman Trust, supra, the argument based on the indirect use of borrowed money was specifically rejected. There the trustees of a trust fund who had followed investment policies which were focused more on capital gains than on income, borrowed money to make capital allocations to the beneficiary instead of selling shares in the trust fund since they were of the view that such sale, at the time, would have been commercially inadvisable. They attempted to deduct the interests paid on the loan as against the income of the trust fund. The Supreme Court of Canada declined to characterize the transaction on the basis of a purported indirect use of borrowed moneys to earn income giving rise to a deduction. According to Dickson, C.J. at page 126 (S.C.R. 48; D.T.C. 5065): ”. . . neither the Income Tax Act nor the weight of judicial authority permits the courts to ignore the direct use to which a taxpayer puts borrowed money."

On the contrary, he said at page 129 (S.C.R. 53-54; D.T.C. 5067):

. . .the text of the Act requires tracing the use of borrowed funds to a specific eligible use, its obviously restricted purpose being the encouragement of taxpayers to augment their income-producing potential. This, in my view, precludes the allowance of a deduction for interest paid on borrowed funds which indirectly preserve income-earning property but which are not directly "used for the purpose of earning income from. . . . property".

There is no tracing here of the borrowed funds to the income earned. The borrowed funds were put to a non-eligible use while the personal funds were used so as to produce income.

The respondent claims that contrary to Bronfman Trust, his assets were income-producing so he finds himself in the special circumstances described by Dickson, C.J. in Bronfman Trust. What Dickson, C.J. said is the following (at page 129 (S.C.R. 54; D.T.C. 5067)):

Even if there are exceptional circumstances in which, on a real appreciation of a taxpayer's transactions, it might be appropriate to allow the taxpayer to deduct interest on funds borrowed for an ineligible use because of an indirect effect on the taxpayer's income-earning capacity, I am satisfied that those circumstances are not presented in the case before us. It seems to me that, at the very least, the taxpayer must satisfy the Court that his or her bona fide purpose in using the funds was to earn income. In contrast to what appears to be the case in TransPrairie, the facts in the present case fall far short of such a showing. . . .

In Trans-Prairie Pipelines Ltd. v. M.N.R., [1970] C.T.C. 537; 70 D.T.C. 6351 (T.C.C.) the appellant company was in the business of constructing and operating a pipeline. At one point in time it needed more capital for expansion. Its Original capital, when it started business in 1954, was composed of common shares and preferred shares. It discovered however it was impossible, practically speaking, to float a bond issue unless it first redeemed its preferred shares, because of the sinking fund requirements of its preferred shares. It therefore had no choice but to redeem its preferred shares. To do so, it paid $700,000 to the holders of the preferred shares. It then borrowed $700,000 by way of a bond and raised a further $300,000 by issuing additional common shares. In the course of carrying out these transactions, the preferred shares were redeemed by using the $300,000 obtained by the new issue of common shares and by taking $400,000 out of the $700,000 received on the floating of the bond issue. The question arose as to whether the appellant was entitled to a deduction of the whole or only part of the interest payable on such bonds by virtue of what was then section 11(1)(c) of the Income Tax Act, R.S.C. 1952, c. 148, a section analogous to subparagraph 20(1)(c)(i) of the Act. Jackett, P. (as he then was) was of the opinion that the whole of the $700,000 was borrowed money used for the purpose of earning income from the appellant's business and not only the $300,000, as claimed by the Minister, with the result that all the interests borrowed on the bonds were deductible. Jackett, P. said at page 541 (D.T.C. 6354) that the whole $700,000 "went to fill the hole left by redemption of the $700,000 preferred". Dickson, C.J., at page 128 (S.C.R. 52; D.T.C. 5066) upheld such reasoning.

The taxpayer, in the case at bar, is far from meeting the special circumstances of Trans-Prairie Pipelines. What was said by Dickson, C.J. in the extract cited above was that ”. . . the taxpayer must satisfy the Court that his or her bona fide purpose in using the funds was to earn income.” The borrowed moneys were not used by the taxpayer to earn income from business or property like they were under the business arrangement described in TransPrairie. They were used to finance the personal residence of the respondent.

I am not called upon to decide what would have been the situation had the respondent used his personal funds to pay off the mortgage, then borrow moneys for investment using his home as collateral security. I express some difficulty however with the contention of the respondent that the difference between such an arrangement and the present one would simply be one of form. But in final terms, what was said by Dickson, C.J. at page 129 (S.C.R. 55; D.T.C. 5067) in Bronfman Trust, governs the present case: ”. . . the courts must deal with what the taxpayer actually did, and not what he might have done, Matheson v. The Queen, [1974] C.T.C. 186 at 189; 74 D.T.C. 6176 at 6179 (F.C.T.D) per Mahoney, J.”

The case at bar is not one where the borrowed moneys can be traced to a specific eligible use.

The B.B.P. Sinha case cited by Dickson, C.J. at page 125 (S.C.R. 47; D.T.C. 5065) and on which the trial judge relied, represents an entirely different factual situation from the case at bar. There, a change occurred from the original purpose of the loan but the use to which the borrowed money was put was an eligible one. The taxpayer in question borrowed money as a Canada Student Loan at an advantageous interest rate. He did not need the funds so he decided to invest them so as to earn a profit. He deducted the interest expenses. The Minister disallowed the deduction on the ground that the funds, originally borrowed for personal reasons, retained that character during the material time. The Tax Review Board held that although the original purpose for which the loan had been made had changed the use of the borrowed money during the year in question was used to earn income and not to further the taxpayer's education. The requirements of subparagraph 20(1)(c)(i) were met since the current use of the borrowed money was an eligible one. [3]

I would allow the appeal, set aside the decision of the trial judge and restore the reassessments made earlier by the Minister in which he disallowed the amounts claimed by the respondent as interest deductions for the years 1980, 1981 and 1982, and as detailed, supra.

In accordance with subsection 178(2) of the Act, [4] I would order that the respondent be entitled to his costs in the appeal.

Crown's appeal allowed.