Jack Harrand v. Minister of National Revenue, [1987] 1 CTC 2026, 86 DTC 1855

Tremblay, T.C.J.:—This appeal was heard on June 16, 1986 in the City of Regina, Saskatchewan.

1. The Point at Issue

The point is whether the appellant, a businessman living in Regina, is correct in the computation of his income for the 1981 taxation year to deduct an amount of interest of $11,004.35.

Despite the fact that the capital amount of $72,957, on which was paid the said interest, was used to pay the existing mortgage of his principal residence, the appellant claimed the deduction of the said interest. He contends that the sum of $72,957 is part of the $475,000 borrowed by him to invest in a Canadian company. The lender, the Royal Bank, required that the existing residential mortgage in favour of the Bank of Montreal be previously paid so that the principal residence, a cottage and farm land could be used as guarantee.

The respondent disallowed the said amount of $11,004.35 on the basis that the capital was used to pay the existing residential mortgage and therefore, it was not for the purpose of gaining income.

Alternatively the appellant contends that at least $5,520.35 of interest should be allowed. Indeed this amount, he says, comes from the difference between 10.5 per cent of the existing interest with the Bank of Montreal and the effective rate of 19.5 per cent with the Royal Bank. The latter required such change of the mortgage in its favour to lend the amount of $400,000 which was invested in a Canadian company, for the purpose of gaining income.

2. The Burden of Proof

2.01 The burden of proof is on the appellant to show that the respondent's assessment is incorrect. This burden of proof results particularly from several judicial decisions, including the judgment delivered by the Supreme Court of Canada in Johnston v. M.N.R., [1948] C.T.C. 195; 3 D.T.C. 1182.

2.02 In the same judgment, the Court decided that the assumed facts on which the respondent based his assessment or reassessment are also deemed to be correct. In the present case, the assumed facts are described in the reply to notice of appeal as follows:

5. In reassessing the appellant for his 1981 taxation year and, in respect of the matters in issue he made, inter alia, the following assumptions of fact:

(a) During his 1981 taxation year the appellant borrowed $75,000.00 from the Royal Bank of Canada in order to pay off the principal amount of $72,957.00 outstanding in respect of an existing mortgage upon his principal residence.

(b) The said loan of $75,000 was secured by a mortgage placed as a first charge against the appellant’s principal residence.

(c) In 1981 the appellant paid interest of $11,004.35 in respect of $72,957.00 of

the principal amount of the mortgage referred to in subparagraph 5(b) herein.

(d) The said $11,004.35 was not paid pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from a business or property.

(e) The amount $11,004.35, paid as aforesaid, constituted a personal expense of the appellant.

3. The Facts

The material facts are not in dispute.

3.01 Mr. Harrand had a mortgage on his personal residence with the Bank of Montreal for approximately $73,000 at 10.5 per cent which expired on October 31, 1983.

3.02 In February 1981 Mr. Harrand applied to the Royal Bank to borrow $400,000 for the purpose of purchasing shares in Pioneer Steel Corporation Ltd., of which he was to become a major shareholder. (Exhibit A-4)

3.03 In February 1981 and subsequent months the lending rate was 19.5 per cent (prime rate 18.25 per cent plus 1.25 per cent). (Exhibit A-2)

3.04 The primary assets which Mr. Harrand had available to grant as security for the $400,000 loan were his principal residence (valued in excess of $200,000), a cottage owned by his wife, and farm land owned by Quest Management Corporation which was owned jointly by Mr. Harrand and his wife. (Exhibits A-3, A-5)

3.05 As stated in the affidavit of Andy R. Meiers (Exhibit A-1 accepted as evidence), the Royal Bank of Canada, as a condition of granting its loan approval required first mortgage security on all of the foregoing real property and accordingly required Mr. Harrand to borrow an additional $75,000 on the same terms to pay out the existing mortgage on his principal residence.

4. Law — Cases at law — Analysis

4.01 Law

The main provision involved in this case is 20(1 )(c) of the Income Tax Act. It reads as follows:

SEC. 20. Deductions permitted in computing income from business or property.

(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) 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).

4.02 Cases at Law and Doctrine

The cases at law and doctrine referred to the Court by counsel for the parties are as follows:

1— Canada Safeway Limited v. M.N.R., [1957] C.T.C. 335; 57 D.T.C. 1239,

2— C.A. Auld v. M.N.R., 28 Tax A.B.C. 236; 62 D.T.C. 27,

3— Joel Sternthal v. The Queen, [1974] C.T.C. 851; 74 D.T.C. 6646,

4— George Eelkema v. M.N.R., [1983] C.T.C. 2311; 83 D.T.C. 253,

5— William Landrey v. M.N.R., [1985] 1 C.T.C. 2313; 85 D.T.C. 275,

6— David Asmoucha v. M.N.R., [1986] 1 C.T.C. 2383; 86 D.T.C. 1299,

7— S. M. Attaie v. M.N.R., [1985] 2 C.T.C. 2331; 85 D.T.C. 613,

8— The Estate of W. C. Cochrane v. M.N.R., [1976] C.T.C. 2215; 76 D.T.C. 1154,

9— Phyllis Barbara Bronfman Trust v. The Queen, [1983] C.T.C. 253; 83 D.T.C. 5243,

10— Johns-Manville Canada Inc. v. The Queen, [1985] 2 C.T.C. 111; 85 D.T.C. 5373,

11— Trans-Prairie Pipelines Ltd. v. M.N.R., [1970] C.T.C. 537; 70 D.T.C. 6351,

12— Vern Krishna — "Deductibility of Interest” — Canadian Current Tax, issues 29 & 30 — July 1983.

4.03 Analysis

4.03.1 The first requirement of subparagraph 20(1 )(c)(i) of the Act that the money be paid or payable pursuant to a legal obligation to pay interest, is not in dispute.

The point in dispute is whether the money borrowed by the appellant was used for the purpose of earning income from a business or property.

There are two tendencies pursuant to which the Courts construe the use of the borrowed funds and therefore conclude the deductibility or not of the interest: first, the purpose underlying the use of borrowed money. Or as presented in another way by Mr. Vern Krishna (4.02(12) ):

There are two ways in which one can look to the use of borrowed funds. The direct use can be traced by following the funds from the lender to the investment in which the funds are applied. The indirect use of funds can be examined by asking the question: did the use of the borrowed funds facilitate the investment of other funds in an income producing process?

4.03.2 Without giving the detailed facts involved in the following cases at law referred to the Court, let us say that in 1957 the Supreme Court of Canada in Canada Safeway Limited case (4.02(1)); in 1962, the Tax Appeal Board in C. A. Auld case (4.02(2)); in 1974, the Federal Court of Canada — Trial Division — in Joel Sternthal case (4.02(3)); in 1985, the Tax Court of Canada in William Landrey case (4.02(5)); again the Tax Court of Canada in 1986 in the David Asmoucha case (4.02(6)), the Courts all apply the way of the direct use: it was the direct use made of the borrowed money that determined its deductibility, the interest was not deductible.

4.03.3 The second tendency of the Courts was mainly stressed in 1970 by the Exchequer Court of Canada in the Trans-Prairie Pipelines Ltd. case (4.02(11)); in 1976 by the Tax Review Board in The Estate of W. C. Cochrane case (4.02(8)); in 1983, by the Federal Court of Appeal in the Bronfman Trust case (4.02(2)).

The facts of the latter case are summarized by the Federal Court of Appeal in its decision given by Thurlow, C.J. at 254 (C.T.C.) and at 5243 (D.T.C.).

The issue in this appeal is whether the appellant, in computing its income for tax purposes for the years 1970, 1971 and 1972, is entitled to deductions for interest amounting to $110,114 in 1970, $9,802 in 1971 and $1,432 in 1972, which the appellant paid on two bank loans, one in the amount of $300,000 (US) obtained in December, 1969, the other in the amount of $1,900,000 (Can) obtained in March, 1970. The latter loan was repaid in full by October 5, 1970, following the sale of certain investments in Gulf Canada Ltd. The former was substantially reduced in 1970 and 1971 and the balance was repaid in full on January 4, 1972.

The appellant is a trust established in 1942 by Samuel Bronfman in favour of his daughter. Under the deed of trust the daughter, as beneficiary, is entitled to receive annually 50 per cent of the income from the trust property and may from time to time be assigned, at the discretion of the trustees, capital allocations. At the material times the assets of the trust, almost all of which were invested in income earning securities, had a cost base of about $15,000,000 and a fair market value estimated at more than $70,000,000. The bulk of the value was represented by investments in family enterprises and was not readily realizable. The remainder was invested in marketable securities. But at the times when the loans in question were obtained it was inexpedient to sell some of them because their market value was depressed and others could not be sold immediately because they were temporarily pledged for the indebtedness of a family holding company.

At 255 (C.T.C.) and at 5244 (D.T.C.), Thurlow, C.J. said:

It is, I think, unrealistic to focus attention on the use of the borrowed money to pay the capital allocations. What appears to me to matter for this purpose is the effect which the use of the borrowed money to pay the allocations had on the ability of the trustees to keep the income earning investments and continue to earn for the trust the whole of the income therefrom. What the statute refers to is the purpose of earning income from property, by the exploitation of that property itself. In this case property to be exploited consisted of the trust investments being held by the trustees. The focus of the statute is thus the purpose of the trustees in continuing to hold the investments. If that purpose was to earn income from them and the money was borrowed to enable them to do so — to carry out that purpose — the requirement of the statute is satisfied. It does not matter that the method of accomplishing the purpose was not to buy securities with the borrowed money rather than to continue to hold what the trust already had by using the proceeds of the loans to discharge an obligation which if not discharged in that way would have made it necessary to give up a portion of the income earning investments of the trust. Nor, in my opinion, does it matter that the trustees in continuing to hold the investments may have had as well an eye to the possible appreciation of their capital value.

Hyde, D. J. agreed with the Chief Justice Thurlow, however Pratte, J. disagreed with him and confirmed the decision of Marceau, J. of the Federal Court — Trial Division, saying the borrowed money was not “used for the purpose of earning income from a business or property” but it "was, in fact, used to pay the capital allocations made by the trustees in favour of Miss Bronfman”. He adds: "The appellant’s argument, in my view, ignores the language of the Act”.

An appeal was lodged by the Minister of National Revenue to the Supreme Court of Canada.

4.03.4 In 1978, as a member of the Tax Review Board, I heard the first appeal of Phyllis Barbara Bronfman Trust and would have allowed the appeal as I indicated in my decision ([1978] C.T.C. 3088 at 3095; 78 D.T.C. 1752 at 1757) had the appellant proved that a sale of trust assets (shares of Gulf Oil of Canada) at the time of making the capital allocation would have resulted in a loss of revenue to the trust. My decision would then have been based on The Estate of W. C. Cochrane case (4.02(8)) that I then quoted at length. The latter referred, among others, to a decision of Associate Chief Justice Noël, The Queen v. F. H. Jones Tobacco Sales Company Ltd. ([1973] C.T.C. 784; 73 D.T.C. 5577), and also to Hallstroms Pty. Ltd. v. F.T.C. (8 A.T.D. 190). In the latter, it was said that a realistic attitude must be adopted towards decision of expenses or losses. Indeed, it stated that in such cases the solution "depends on what the expense is calculated to effect from a practical and business point of view, rather than upon a juristic classification of the legal rights, if any, secured, employed or exhausted in the process”.

In my view, the decision of Thurlow, C.J. is based on the same principle. In the instant case again, in my opinion, the same principle must apply. The appellant indeed would not have, in normal circumstances, borrowed money at a rate of 19.5 per cent interest to pay a mortgage at a rate of 10.5 per cent. It is only because he had to pay the mortgage registered in favour of the Bank of Montreal to permit a better guarantee in view of obtaining a borrowing of $400,000 from the Royal Bank. The purpose of this borrowing was to purchase shares of Pioneer Steel Corporation Ltd. of which he was to become a major shareholder.

It seems to me that from a practical and business point of view, the purpose of the borrowing (the purchase of shares of Pioneer Steel Corporation Ltd.) dominates the whole transaction. The rest, including the payment of the existing mortgage, is only ancillary to the result of the main borrowing. In my view, all the interest must be considered as the interest paid for the borrowing used for the purchase of said shares. The expense was then "used for the purpose of earning income from a busines or property”.

5. Conclusion

The appeal is allowed with costs for the reasons given above.

Appeal allowed.