John Shore v. Minister of National Revenue, [1986] 1 CTC 2360, 86 DTC 1253

Taylor, T.C.J.:—This is an appeal heard in London, Ontario, on January 22, 1986, against income tax assessments for the years 1980, 1981, and 1982 in which the Minister of National Revenue disallowed as an interest expense deduction the amounts of $4,193, $4,125 and $4,051 respectively. The notice of appeal, prepared by Schooley & Mitchell, Chartered Accountants, Stratford, Ontario, read as follows:

Facts

1. Mr. Shore incorporated a company in 1977 to acquire the assets and liabilities of an automobile dealership in Stratford, Ontario. To finance the acquisition, Mr. Shore arranged for a personal loan (mortgage) secured by his personal residence in Thamesford, Ontario and loaned the proceeds to the limited company at the same interest rate as he incurred. A relocation to Stratford was contemplated at this time but there were no prospective buyers interested in the Thamesford residence.

In 1979, the demands of the business dictated that Mr. Shore had to relocate. Mr. Shore accepted an offer to purchase on the Thamesford property and on closing the personal loan (mortgage) was assumed by the new owner. The option to maintain the loan was not available as the title to the security had changed.

In Stratford, Mr. Shore and family resided with relatives for a brief period until a suitable personal residence was located. On the acquisition of the new residence, Mr. Shore assumed an existing mortgage for approximately the same amount as that which existed at the time of selling the Thamesford property. The limited company indebtedness to Mr. Shore continued to incur interest expense at the same rate as that on the original loan throughout the entire period.

2. Treatment For Income Tax Purposes

A) As filed

In all years 1977 through 1982, interest expense incurred on the loan (mortgage) was deducted as an expense under section 20(1 )(c) and interest income from the loan to the corporation was reported. The two amounts ‘netted’ themselves for a nil effect on taxable income.

B) Per assessment notice

The tax department indicates that the loan interest incurred on the loan secured by the Stratford property is not deductible and is of a personal nature.

3. Grounds For Appeal

A) Section 20(3) of the Income Tax Act is to be read in conjunction with Section 20(1)(c). Section 20(3) indicates that the refunding (refinancing) of loans does not alter the purpose for which the original funds were used and the deduction of any related interest expense.

It is the taxpayer’s contention that this is the situation in the facts outlined previously other than the taxpayer’s inability (by law) to retain the original loan at the time of disposing of the Thamesford property. The events should be viewed as a series of related transactions rather than isolating each particular component.

B) Mr. Shore entered into the series of transactions in a manner so as to obtain the best financial results. Had there been any doubt as to the deductability (sic) of the interest in this instance he could have simply obtained a demand loan to pay off the Thamesford loan and not assumed a mortgage on the acquisition of the Stratford property. Demand loan interest rates are traditionally higher than mortgage interest rates and consequently the decision to mortgage was made.

It appears that form rather than substance has prevailed in the tax department's assessment. Mr. Shore conducted his affairs in the most efficient manner and his personal financial position was not improved as a result of the transactions.

Further details were provided in the Minister’s reply to notice of appeal:

— In or about 1978, the Appellant received a loan from Guaranty Trust, which loan was secured by a first mortgage on his personal residence located in Thamesford, Ontario.

— The proceeds of the loan referred to in paragraph 2 herein, approximately $41,061, were immediately loaned by the Appellant to a corporation which he controlled, i.e. Joline Automobiles Ltd. and used by the said corporation for business purposes. Joline Automobiles Ltd. agreed to pay the Appellant interest and principal equal to the amount he had to pay Guaranty Trust.

— In or about November 1979, the Appellant sold his personal residence in Thamesford, Ontario, with the purchaser of the said residence assuming the Guaranty Trust mortgage.

— Subsequent to the sale of his personal residence in Thamesford, Ontario, the Appellant purchased a home located in Stratford, Ontario, assuming a first mortgage with Victoria and Grey Trust in the sum of approximately $42,675. The assumption of this mortgage was considered as payment in part of the purchase price.

— In 1980, 1981 and 1982, the Appellant deducted the interest paid on the Victoria and Grey mortgage which he had assumed with respect to the purchase of his new residence, against the interest earned from the original loan made to Joline Automobiles Ltd. Joline Automobiles Ltd. had upon the Appellant purchasing his new residence, and assuming the mortgage thereon, agreed to pay the Appellant interest and principal equal to the amount paid by the Appellant to Victoria and Grey Trust.

In so reassessing the Appellant the Respondent found or assumed:

— that the assumption of the Victoria and Grey Trust mortgage on his second residence by the Appellant, did not provide proceeds to the Appellant which he could in turn loan to Joline Automobiles Ltd.;

— that the loan received by the Appellant secured by the mortgage granted to Guaranty Trust on the Thamesford residence was assumed by the purchaser of the Appellant's residence in Thamesford, and as such the Appellant is no longer required to make interest and principal payments with respect to this loan;

— as of November 1979, the Appellant was not indebted to Guaranty Trust;

— the proceeds of the Victoria and Grey mortgage were not used to pay off

the Guaranty Trust mortgage, nor were they lent to Joline Automobiles Ltd.;

— The interest expense paid by the Appellant on the mortgage he assumed on his new residence is a personal or living expense of the Appellant and as such is not deductible from his other income. The interest paid by Joline Automobiles Ltd. pursuant to the loan made by the Appellant in or about 1978, is income taxable under the Act.

The respondent relied, inter alia, upon paragraphs 18(1)(a), 18(1 )(h) and 20(1)(c) of the Income Tax Act, R.S.C. 1952, chapter 148, as amended (the "Act").

There was no dispute about the facts of the case, and Mr. Shore provided the Court with additional details as required. The chronology of events as seen by the Court corresponded to the overview provided by the respondent in the reply to notice of appeal (supra). In effect during the years in question Mr. Shore had simply ignored both the interest income effectively "received" from Joline Automobiles Ltd., ("Joline") and the corresponding similar amount effectively paid on his house mortgage. The amounts added to income by the Minister represented the amounts of interest paid by Joline and deducted as an interest expense by that company. There was no corresponding "set-off" allowed by the Minister.

First, it might be useful to set out for the record that the Minister, as far as the Court is aware, did not disallow as a business deduction the interest paid by Joline. The agent for the appellant did not object to the assertion by the Minister that this amount was taxable income in the hands of Mr. Shore. Nor did the Minister disagree, in principle, with the proposition of the agent for the appellant that had Mr. Shore followed some other process to accomplish the same thing, that the amounts in question might still be deductible. For example, had Mr. Shore obtained "bridge financing" for the period when he sold his first house and bought the second one, paid off with these funds the Guaranty mortgage, managed to buy the new home with his own funds, and then place a mortgage on the new home, and use the proceeds from that to pay of the "bridge financing", Mr. Shore would have a very substantial claim for continuing deductibility of his interest expenses from his interest income. The agent for the appellant asserted that in effect Mr. Shore had done that, only making allowance for the practicalities and the most sensible business-like way in which to accomplish it. In his view, subsection 20(3) of the Act should provide for the relief sought.

Obviously Mr. Shore could see no difference at all between what he had been doing, and that which he was now doing. Ultimately, therefore, the Minister's assessment is based not upon a disagreement with the conduct, objective, or intent of the appellant, but on the fact that he did not follow the technicalities of the procedures available under subsection 20(3) of the Act for such exigencies.

One should recognize that it is not the interest on the mortgage on the home (even the first home) which is a deductible expense to Joline. It is the interest on the loan (of the proceeds of this mortgage) provided by Mr. Shore to Joline. Joline has no “legal obligation to pay interest" on the mortgage — paragraph 20(1)(c) of the Act. It may well have been, and the Court understood it to be the situation in this case, that Joline paid the interest directly to Guaranty Trust (and later to Victoria and Grey Trust), rather than first to Mr. Shore, who then could pay the holder of the mortgage. But that would only be a matter of internal convenience — it would not change the tax principle involved. When the business procedure did not change after the change of home, other than a different address for the cheques, it is little wonder Mr. Shore is perplexed by the taxing result.

Subsection 20(3) of the Act has been little adjudicated over the years, and that may be due to what is seen as its clarity of intent, resulting from the use of specific words like "borrowed money", and "repay". I would note with appreciation one such reference to that section to be found on page 325 (D.T.C. 5237) of Russell I. Emerson v. The Queen, [1985] 1 C.T.C. 324; 85 D.T.C. 5236:

I agree with the Plaintiff that 20(3) deems that monies borrowed to repay are given the same tax treatment as the original monies. [Subsection] 20(3) reads:

(3) Idem. For greater certainty, it is hereby declared that where a taxpayer has used borrowed money

(a) to repay money previously borrowed, or

(b) to pay an amount payable for property described in subparagraph (1)(c)(ii) previously acquired,

the borrowed money shall, for the purposes of section 21 and paragraph (1)(c) or (k), be deemed to have been used for the purpose for which the money previously borrowed was used or was deemed by this subsection to have been used, or to acquire the property in respect of which the said amount was so payable, as the case may be.

However, does that help the Plaintiff in the facts of this case? I do not believe so. Clearly, if the Plaintiff had moved from District Trust to Royal Bank to secure the financing for the purchase of the shares in Lonmed Holdings Limited, Medion Small Business Development Limited and Arcturus Small Business Development Limited and had retained these shares, in my view this section provides the vehicle necessary to maintain his right to a deduction. Here, however, the shares were disposed of.

Reference is also made in the comments contained in Distillers Corporation Limited v. M.N.R., [1974] C.T.C. 2258; 74 D.T.C. 1197.

While the purpose for which subsection 20(3) was placed in the Act is quite clear — to provide a means of continuing the deductibility of certain interest payments when the source of financing an obligation has changed

— it is argued by the Minister that specific caution must be exercised in any procedure akin to refinancing, if deductibility is to be preserved. That is indeed a very proper position for the Minister to take, and the Minister put forward in support of that proposition, the case of Dorman v. M.N.R., [1977] C.T.C. 2355; 77 D.T.C. 251. The appellant therein was unsuccessful in contending that a mere substitution of the security had taken place. That would certainly be the appropriate result of this appeal if the most strict construction of subsection 20(3) of the Act were upheld. However if one views the purpose of subsection 20(3) of the Act in the light of its positive effect as “refinancing” rather than in its elements of “borrowing” and “repaying”, there is justification in looking at Mr. Shore's proposition in a larger light — and bringing into the context the recent cases of Phyllis Barbara Bronfman Trust v. The Queen, [1983] C.T.C. 253; 83 D.T.C. 5243, and Stubart Investments Limited v. The Queen, [1984] C.T.C. 294; 84 D.T.C. 6305. From Bronfman Trust (supra) at 255 (D.T.C. 5245), I would quote:

. . . 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 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 as an eye to the possible appreciation of their capital value.

And from Stubart (supra) at 315 (D.T.C. 6322):

Indeed, where Parliament is successful and a taxpayer is induced to act in a certain manner by virtue of incentives prescribed in the legislation, it is at least arguable that the taxpayer was attracted to these incentives for the valid business purpose of reducing his cash outlay for taxes to conserve his resources for other business activities. It seems more appropriate to turn to an interpretation test which would provide a means of applying the Act so as to affect only the conduct of a taxpayer which has the designed effect of defeating the expressed intention of Parliament. In short, the tax statute, by this interpretative technique, is extended to reach conduct of the taxpayer which clearly falls within “the object and spirit’ of the taxing provisions. Such an approach would promote rather than interfere with the administration of the Income Tax Act, (supra), in both its aspects without interference with the granting and withdrawal, according to the economic climate, of tax incentives. The desired objective is a simple rule which will provide uniformity of application of the Act across the community, and at the same time, reduce the attraction of elaborate and intricate tax avoidance plans, and reduce the rewards to those best able to afford the services of the tax technicians.

I am all too conscious of the fact that neither of these two erudite judgments touches precisely on the point at issue here, but it seems to me (albeit I do admit to considerable reservation about it) that the "interpretation test”, the "object and spirit” of the Act, when applied to the circumstances of this appeal should lead to a conclusion that "the requirement of the statutes is satisfied” by the conduct of this appellant.

The appeal is allowed and the matter referred back to the respondent for reconsideration and reassessment. The appellant is entitled to party and party costs.

Appeal allowed.