June Lee and Suk Lee v. Minister of National Revenue, [1989] 2 CTC 2228

Mogan, T.C.J.:—The appellants are husband and wife and their appeals were heard together on common evidence. In 1969, they came to Canada from Korea as a young couple and they became Canadian citizens in 1973. After working for a number of employers, Mr. Lee started his own business in 1978 at London, Ontario, under the name “Oriental Trading". In 1984, the appellants were living in a townhouse in London with three young sons. Living conditions were crowded and the appellants decided to purchase a four bedroom house so that each of the sons could have his own room.

In 1984, the appellants had saved $54,000 in cash and they were looking for new house in the cost range of $ 100,000. During their search for a new house, they saw a newspaper advertisement offering the Rainbow Motel for sale with a "residence component" containing four bedrooms. After inspecting the property, they decided to purchase the motel because the four bedroom residence was acceptable and there was an opportunity to earn additional income from the motel business. In 1984, the appellants purchased the Rainbow Motel for $465,000 and, at the time of the purchase, the vendor and the appellants agreed that the purchase price should be allocated as follows:

The Minister of National Revenue does not challenge the above allocation of the appellants’ purchase price. At the time of purchase, there were additional costs of $4,410 representing land transfer tax ($3,340), legal fees ($1,054) and deed registration ($16). These additional costs were prorated and distributed among the purchased assets other than goodwill.

The aggregate purchase price of approximately $469,000 was assembled by the appellants from the following sources:

Deposit from Oriental Trading $ 5,000

Appellants' cash savings	54,000
Loan from Mr. Lee's brother	25,000
Loan from Mrs. Lee's sister	20,000
Hanil Bank of Korea	25,000
Vendor take back mortgage	340,000
	$469,000

The issue in this appeal is whether the appellants are entitled to deduct in computing income all of the interest paid with respect to the vendor take back mortgage ("VTB mortgage").

Mr. A. Smit, a tax consultant and advisor to the appellants, appeared as a witness and produced a schedule (Exhibit A-2) allocating the area of the building between the motel and the house and further allocating the area of the house between rooms used for personal residence and rooms used in connection with the motel business. According to Mr. Smit's calculations, the total area of the motel and house was 9,041 square feet of which 1,391 square feet (15.38 per cent) were used for the personal residence of the appellants and their family. Mr. Smit prepared Exhibit A-2 so that he would have a basis for allocating certain common expenses like insurance, heating and hydro. Revenue Canada, Taxation has accepted the calculations in Exhibit A-2 as a reasonable basis for allocating such operating expenses.

The taxation years under appeal are 1984 and 1985. In each of those years, the appellants deducted in computing income all of the interest paid to the vendor of the motel with respect to the VTB mortgage. The respondent disallowed 15.38 per cent of such interest on the basis that it was a personal or living expense within the meaning of paragraph 18(1 )(h) of the Income Tax Act or on the basis that 15.38 per cent of the principal amount of the VTB mortgage was not an amount payable for property acquired for the purpose of gaining or producing income from a business (i.e. the motel business) within the meaning of subparagraph 20(1)(c)(ii) of the Act.

Counsel for the appellants argued that they are entitled to deduct in computing income all of the interest on the VTB mortgage because (i) they had $54,000 in cash savings to buy a house; (ii) they purchased the Rainbow Motel for the dual purpose of acquiring a residence and acquiring a business; (iii) they would never have paid $465,000 for a house alone; (iv) the residence portion of the purchase price was $40,000; (v) they used only $40,000 of their cash savings to purchase the residence portion of the building; and (vi) all remaining funds plus the VTB mortgage were used to purchase the business assets of the Rainbow Motel.

I have difficulty in accepting that argument. All of the property comprising the Rainbow Motel (land, building, fixtures, chattels, swimming pool and goodwill) was purchased in a single transaction pursuant to one agreement of purchase and sale dated April 15, 1984 (Exhibit A-4). The agreement stated that the purchase was to be completed on or before the 15th day of July 1984. The cash funds and security required to complete the purchase were obtained from different sources and assembled in a common pool. There is nothing in the agreement of purchase and sale which allocates the purchase price ($465,000) among the various assets or identifies the purchase price of a particular asset as being derived from a particular source. It was only in a collateral document dated July 12, 1984 (Exhibit A-3) that the appellants and the vendor agreed to allocate the purchase price among the assets as shown above; and even at that late date, there was no attempt to identify a particular component of the purchase price pool with a particular asset.

Money is fungible or interchangeable in the sense that one dollar cannot be distinguished from another. Therefore, when the appellants’ funds were assembled in a common pool to complete the purchase, it was impossible to identify a particular source of purchase money with a particular asset purchased. It is only in the appellants’ minds (and perhaps after the fact) that their cash savings of $54,000 should be regarded as the only source of funds to purchase the residence component of the motel. The vendor would not have been aware that there was any such notional source and application of purchase funds if, indeed, the appellants had such a notion at the time of purchase.

When a person purchases a number of different assets (real estate, chattels and goodwill) in a single transaction and assembles the purchase price partly from his own funds and partly through a vendor's mortgage, there are business factors which operate against any attempt by the purchaser to trace all or part of his own funds through to a particular asset. A mortgagee will rarely advance funds and accept a mortgage for the full value of the mortgaged property. Normally, a mortgagee will want the mortgagor to advance at least a portion of the purchase price and acquire some equity in the mortgaged property so that the mortgage itself will be for an amount less than the fair market value of the property. In circumstances like those under appeal, when virtually all of the value in the purchased assets (land, building, fixtures and swimming pool) are subject to the VTB mortgage, the business sense of the vendor/mortgagee would induce him to regard the cash paid on closing as referable, firstly, to the non-mortgaged assets (chattels and goodwill) and, secondly, to all mortgaged assets prorata. Following this notional application of purchase funds, the vendor/mortgagee can determine how much equity the purchaser has acquired in the mortgaged assets.

It would therefore appear that both the purchaser and vendor perform a notional application of the purchase funds each for his own purpose. The purchaser allocates his own capital to non-business assets so that the borrowed capital will be allocated to business assets and all interest on the borrowed capital will be deducted in computing income. The vendor allocates the cash paid on closing, firstly, to non-secured assets and, secondly, to mortgaged assets in order to determine how much equity the purchaser has actually acquired in the mortgaged assets. An objective third party viewing the transaction would probably allocate all funds in the purchase pool prorata among all purchased assets.

Counsel for the appellants relied on the recent decision of this Court in Wilson v. M.N.R., [1988] 2 C.T.C. 2053; 88 D.T.C. 1418 in which Mr. Wilson purchased for $238,000 a one-acre parcel of land fronting on the Fraser Highway in Aldergrove, B.C. In order to satisfy the purchase price, Mr. Wilson conveyed to the vendor his home in White Rock at an agreed value of $122,000 and he placed a mortgage on the one-acre parcel for the remaining $116,000. The one-quarter acre fronting on the highway was zoned commercial and valued at $130,400 while the three-quarter acre containing Mr. Wilson’s house was zoned agricultural and valued at $107,600. It was his intention to establish a grocery and convenience store business on the front one-quarter acre zoned commercial.

When Mr. Wilson deducted in computing income all of the interest on the $ 116,000 mortgage, the Minister disallowed approximately 45 per cent of the interest representing the value of the agricultural/residence parcel ($107,600) in relation to the value of the whole parcel ($238,000). This Court allowed Mr. Wilson’s appeal and permitted him to deduct all of the interest on the $ 116,000 mortgage. The Wilson case is different from the appeal herein because Mr. Wilson did not purchase the assets of an ongoing business and his purchase price was not obtained from a number of sources and then assembled in a common pool of fungible property. He purchased only land plus a dwelling. Apparently, there was sufficient evidence to conclude that Mr. Wilson had swapped his former home in White Rock for his new home on the agricultural portion of the one-acre parcel; and the excess value of the White Rock home ($ 14,000) spilled over to the commercial portion of the one-acre parcel on which he intended to establish the grocery/convenience store.

The appellants also relied on the decision of the Federal Court-Trial Division in The Queen v. Attaie, [1987] 2 C.T.C. 212; 87 D.T.C. 5411. In that case Mr. Attaie came to Canada from Iran and borrowed $54,000 to purchase a house. The loan was secured by an open mortgage repayable at any time because Mr. Attaie expected to receive approximately $200,000 from Iran. When the funds arrived from Iran, the interest rates on term deposits were higher than the interest rate on his house mortgage and so he purchased term deposits rather than pay off the house mortgage; and he thereafter deducted when computing his own income the interest paid on the house mortgage. The Minister disallowed such deduction. The Court allowed Mr. Attaie's appeal and followed the Bronfman case, holding that deductibility is determined by the current use of borrowed money and not by its original use.

In these appeals, Mr. and Mrs. Lee are attempting to deduct interest on a portion of commingled funds and there is no question of current use versus original use. The Attaie case does not assist the appellants because it is not concerned with an attempt to allocate purchase moneys out of a common pool or trace funds from a particular source through a single transaction to a particular asset. Lastly, the appellants cited Paramount Bio-Chemicals Ltd. v. M.N.R., [1986] 1 C.T.C. 2206; 86 D.T.C. 1144 but it can be distinguished on its facts.

In my view, there is not sufficient evidence to justify a finding that the full amount of the VTB mortgage was payable for only business assets. Also, on the facts, it would not be reasonable to so regard the VIB mortgage. On the primary issue, the appellants fail. They are not entitled to deduct in computing income all of the interest paid with respect to the VIB mortgage.

In the event that they lose on the primary issue, the appellants raise a secondary issue as to whether 15.38 per cent of the mortgage interest is the correct portion to disallow. When property comprising land and building is subject to a mortgage, if 15.38 per cent of the building is used as a personal residence and the remainder is used for business, it would ordinarily be reasonable to regard 15.38 per cent of the mortgage interest as a personal and living expense and disallow that portion of the mortgage interest as a deduction in computing income.

In these appeals, however, the motel required additional land for its driveway, parking area and swimming pool disproportionate to the land required by an ordinary family dwelling. Also, the survey (Exhibit A-6) seems to indicate redundant land. Upon this secondary issue, counsel for the appellants argued that the appropriate portion of the mortgage interest to disallow (if any) would be 8.6 per cent being the percentage that the cost allocated to the residence ($40,000) is of the total cost ($465,000). I reject that argument because the $40,000 allocated to the residence portion of the building did not take into account the value of any underlying land required to support the residence. Relying on computations which are only approximate, I conclude that 12.5 per cent of the amount of the VTB mortgage is referable to the cost of the appellants' residence component of the Rainbow Motel. Accordingly, 12.5 per cent of the interest on the VTB mortgage should be disallowed as a deduction in computing income.

The appeals herein are allowed in part and referred back to the respondent for reconsideration and reassessment in accordance with the above reasons. The appellants are allowed one set of costs (as for one appeal) to be taxed.

Appeals allowed in part.