Fernwood Construction of Canada LTD v. Minister of National Revenue, [1985] 1 CTC 2289, 85 DTC 257

Sarchuk, TCJ:—Fernwood Construction of Canada Ltd, a private company incorporated pursuant to the laws of the Province of Alberta, carries on the business of real estate construction, development and sale. In reporting its income for the 1979 taxation year the appellant sought to deduct amounts aggregating $480,000 with respect to accrued interest payable to its shareholders. In 1980, the sum of $150,000 was paid to the shareholders. In 1982 the Minister reassessed the appellant in respect of its 1979 taxation year and in so reassessing disallowed as a deduction the amount of $330,000 being the balance of the interest expense claimed as a deduction by the appellant.

At issue in this appeal is whether the Minister of National Revenue was correct in reassessing on the basis that the said sum did not represent payment of interest but rather constituted a distribution of profits to the appellant’s shareholders with the consequence that such amount could not be deducted in computing the appellant’s profit and that, in any event, the deduction of the said amount would not be reasonable in the circumstances and is prohibited by virtue of the provisions of section 67 of the Income Tax Act.

The appellant, incorporated in 1966, is controlled by the principal shareholder Mr Carl Rusnell (Rusnell) and his wife. A chartered accountant, Rusnell practises in the City of Edmonton, with emphasis on the provision of total tax and accounting services to closely held small corporations. Prior to the taxation year in issue the appellant purchased and sold a number of properties, financed almost exclusively by way of shareholders’ loans made to it by Rusnell and his wife. In 1973, it purchased a 768-acre tract of raw land (Manor Park) with the intention of developing country lots for eventual resale. The purchase price of $2,000,000 was to be paid by way of a cash payment of $300,000 ($100,000 in September 1973 and the balance in April 1974) and by way of a mortgage for $1,700,000. The September payment was made, and the appellant anticipated that the sale of the lots would produce adequate funds to make the April payment. When this did not occur it became necessary for the appellant to sell an interest in the project to several joint venturers. In 1976, the joint venturers, disenchanted with the lack of progress, sold their interests to the appellant at a price described by Rusnell as “double the price paid by them”. The funds for the repurchase were advanced to the appellant by Rusnell.

Shortly thereafter the appellant received final approval for the development at which time it required additional risk capital to enable it to proceed. A loan of $2.6 million was negotiated with the Bank of British Columbia (the Bank), $1.6 million for the purpose of paying out the existing mortgage and the balance to service and complete the development. The terms demanded by the Bank were, according to Rusnell, extremely onerous. The rate of interest was two per cent per annum over the highest prime lending rate from time to time or 12.25 per cent whichever was greater. All shareholders’ loans were to be assigned and postponed to the Bank. In addition if the appellant needed partial discharges it was required to pay $21,700 for each lot plus two per cent of the eventual gross selling price of each of the residential lots so released.

Rusnell testified that in 1976 following this refinancing he and his wife discussed repayment of their shareholders’ loans by the appellant. After considering all the relevant factors including the tax implications and the substantial amount of risk capital invested by them in the appellant over the years it was agreed that interest equal to 25 per cent of the profit generated by the sale of the lots in the Manor Park project was both appropriate and reasonable. According to Rusnell the payment of interest was premised upon the potential of Manor Park to show a profit and was not to be paid unless and until all of the lots were sold. If there was no profit correspondingly there would be no obligation upon the appellant to pay interest.

The agreement was not reduced to writing. There was no shareholders’ meeting confirming the appellant’s acceptance of the terms sought by the Rusnells. If a decision to pay interest at the rate specified was taken by the appellant such decision was not reflected in the minutes of the appellant. No entries were made accruing this interest in the appropriate financial statements for any of the years 1975-1978 inclusive.

In 1979, the project was completed and the lots sold. The profits relating thereto were reported in 1979 on an accrual basis. For that year the appellants’ financial statements contain an entry showing interest due to the shareholders (in equal proportions) in the amount of $480,000. No portion of the accrued interest was paid until 1980, when a total of $150,000 was paid to Rusnell and his wife in equal amounts. No distinction was made between Rusnell and his wife as to the rate of interest to be paid by the appellant although the amounts advanced by Rusnell to the appellant were substantially greater than those advanced by his wife. The payments were reported by the appellant in its financial statements as a reduction of liability for interest and for tax purposes in its returns as an interest payment.

According to Rusnell the appellant intended to pay an additional $150,000 in 1981, however in the meantime Revenue Canada reviewed the previous income tax returns and indicated that there was a likelihood that the interest expense deductions would be disallowed. By 1982 the appellant was in a less solvent financial position and a creditor bank insisted that no further payments on account of shareholders’ loans or interest be made. In 1983 the appellant went into receivership.

The appellant contended that the amount of $480,000 was an interest expense and was properly accruable in 1979. This proposition was based on the fact that for many years Rusnell and his wife had advanced large sums of capital to the appellant by way of shareholders’ loans and had received no compensation for the use of these funds. In so far as the rate of interest was concerned counsel submitted that the Manor Park project was very speculative, so speculative that other joint venturers relinquished their interests (albeit at a substantial profit) and the Bank would not invest any of its capital unless it received a very high rate of interest and a percentage of the profits. To obtain refinancing it was even necessary for the Rusnells to assign and postpone their shareholders’ loans to the Bank. Accordingly, to protect their position to the extent possible the arrangement relative to interest was made.

It was submitted that although there was no written agreement between Fernwood and the Rusnells and no corporate minutes or resolutions confirming the arrangement as to interest these omissions did not relieve the appellant from its legal obligation to pay the interest. Counsel argued that the evidence supported a finding that a legal obligation existed and that considering the risk involved and the number of years the appellant had the use of the funds advanced by the Rusnells the amounts accrued as interest were not unreasonable.

The respondent’s position was that the amount disallowed was not an interest expense but rather was the distribution of profits and as such was not deductible. The provisions of paragraph 20(l)(c) refer to a legal obligation. There was, according to respondent’s counsel, no evidence that an enforceable agreement existed between the parties. The evidence disclosed nothing more than an understanding that 25 per cent of the profits, if there were profits, would be paid to the shareholders. Such a payment cannot be equated with the payment of interest.

Counsel for the respondent further argued that for an interest expense to be deductible pursuant to subparagraph 20( 1 )(c)((i) of the Income Tax Act* [1] it had to be paid or payable “in respect of the year” and that this phrase meant that the interest was to be paid or payable with respect to the year during which the money was in fact used. In the case at bar the amount of $480,000 did not pertain to the use of the money in 1979, but rather pertained to its use in prior years. There was no apportionment of any kind and no allocation of the interest on an annual basis. Counsel for the appellant had conceded that the 25 per cent interest rate had been struck on the basis that it was for the use of the moneys for a period of at least six years and an interest rate of that magnitude would not be a reasonable per annum rate. Accordingly there was no question that if the amount in issue was to be found to be a true interest expense it pertains to more than one year and could be deductible, if at all, only in part in 1979. There was no evidence before the Court upon which such an apportionment could be made. In support of this position respondent’s counsel relied upon the decision of Sweet, DJ in MNR v Mid-West Abrasive Company of Canada Limited, [1973] CTC 548; 73 DTC 5429 (Mid-West).

Appellant’s counsel sought to distinguish this judgment on the basis that its obligation to pay interest did not arise in any of the years 1976 to 1978 but arose only following the occurrence of a certain event, that being the earning of profit from a particular project, which event did not occur until 1979. It was contended that prior to that point in time the appellant had no legal obligation to pay interest and as such the circumstances were distinguishable.

With respect, the appellant’s position is not sound. In the case of Mid-West its parent company advanced funds to it in 1960 and 1961 repayable with six per cent interest “if requested”. Mid-West was not in a position to make any payments until 1966 at which time the parent company demanded repayment. MidWest paid all of the interest due since 1962 and sought to deduct from its income in the 1966 and 1967 taxation years the amounts so paid. The submissions made by Mid-West’s counsel were remarkably similar to those advanced in this appeal. As summarized by Sweet, DJ at 554 (DTC 5433):

The liability to pay interest arose only after the request for interest was made but that the amount is calculated on the period the loan was outstanding; even though the request was for interest related to prior years as well as subsequent periods there was nothing to accrue or to deduct until the request was made; until the request was made it would not be known whether there would ever be a requirement to pay interest; although the obligation to pay interest was limited to 6% the request, if made, could have been for less than 6%; the phrase ‘‘in respect of the year” determines only the time or taxation year when an amount of interest may be deducted and does not determine the amount which may be deducted.

Mr Justice Sweet rejected those submissions and stated at 554 (DTC 5434):

. . . In order to determine what, if anything, may be deducted in respect of interest on borrowed money in computing the income of a taxpayer for a taxation year it is the wording of the statute which governs. Here the deduction could only be made if circumstances brought the taxpayer within the wording of the relevant legislation, — in this case subparagraph 1 l(l)(c)(i).f [2]

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) . . . 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).

He went on to Say:

In my opinion the words “payable in respect of the year’’ are to be read together with the first two words in paragraph (c), namely “an amount” so that for those who follow the accrual method the paragraph is to read, “an amount. . . payable in respect of the year”. “In respect of the year” refers, in my opinion, to the year during which the borrowed money was used and not to the year in which the lender chose to make the request for interest. . . . (Emphasis added.)

And later:

Consistent with the view that the words “in respect of the year” refer to the year during which the borrowed money was used and not to the year in which the request was made is the nature of interest and the manner in which it accrues according to the learned author in Halsbury’s Laws of England, 3rd edition Vol 27 sec. 6 page 7:

Interest is return or compensation for the use or retention by one person of a sum of money belonging to or owed to another. Interest accrues de die in diem even if payable only at intervals. . . .

In the case at bar, if the Court were to accept the evidence of Rusnell, an agreement was entered into between the shareholders and the appellant at some point in time in 1976. This agreement would have created a legal liability upon the appellant to pay interest in respect of funds previously advanced by the Rusnells to it. Such interest was to be paid at some point in time in the future and then only upon the occurrence of a specific event ie the earning of profit on a particular project. This event might or might not occur as indeed a request might or might not have been made in the Mid-West Abrasive case. In each case the end result is the same. To use the words of Sweet, DJ: “If and when the request is made . . .” or as in the case at bar a profit is made “. . . it would merely be indicative of the time the borrower’s already existing liability for interest is to be discharged by payment.”

There is no doubt that if an agreement to pay interest existed between the shareholders and the appellant such an agreement and the concurrent liability for interest on the part of the appellant was created in 1976. There is little to distinguish the case at bar from the Mid-West case. I concur with the conclusion stated by Sweet, J at 556 (DTC 5435):

. . . regardless of what the technical position regarding the commencement of liability may be and whether it commenced with the delivery of the notes or came into existence upon the request being made, the interest would nevertheless be in respect of the year or years in which it was earned, which would be the year or years in which the borrowed money was used by the borrower. The interest applicable to the time prior to the request would not be interest in respect of the year in which the request for interest was made. (Emphasis added.)

With respect to the appellant’s contention that there was nothing to deduct until the profits were known I again refer to the comments of Sweet, J at 557 (DTC 5435):

If (although here I need not and do not decide the point) until the request for interest is made no deduction for interest was available to the respondent, the fixing, by the request, of the time when the interest became payable cannot change the effect of the legislation giving the right to make a deduction in respect of interest. That right is limited by the legislation.

In my view the reasoning in the case of Mid-West Abrasive v MNR applies to the facts of this case and accordingly this appeal must be dismissed.

Appeal dismissed.