Côte-Reco Inc v. Minister of National Revenue, [1980] CTC 2019

Guy Tremblay [TRANSLATION]:—This case was heard at Quebec City, Quebec on April 19, 1979.

1. Point at Issue

The question is whether for the 1975 and 1976 fiscal year the appellant is correct in claiming, as a deduction in computing net income from its business of selling shoes, the premium paid in 1975, $2,977, and in 1976, $2,388, for temporary life insurance on the life of its principal shareholder, the purpose being to guarantee a line of credit at the bank in accordance with the requirements of the latter.

2. Burden of Proof

The burden is on the appellant to show that the respondent’s assessment is incorrect. This burden of proof derives not from one particular section of the Income Tax Act, but from a number of judicial decisions, including the judgment delivered by the Supreme Court of Canada in R W S Johnston v MNR, [1948] CTC 195; 3 DTC 1182.

3. Facts

3.01 The appellant was incorporated in January 1975 with the purchase and sale of shoes at wholesale as its principal purpose. Its principal place of business is in Deschaillons, county of Lotbiniere.

3.02 In brief, this incorporation was a continuation of the business known as Lucien Côté Deschaillons Enn, which had then existed for over 20 years.

3.03 The principal witness for the appellant (also the principal shareholder) was Mr Réal Côté, the president, manager, comptroller and accountant of the business for over 20 years.

3.04 Around 1968, when the business was doing $300,000 in sales, Mr Cote set himself an objective that in 1975 there would be $5,000,000 in sales; this objective was attained in 1977.

3.05 In 1974, the business had a credit line of $750,000 with its banking institution ($725,000: current credit; $25,000: customer’s note). However, the company needed new credit (to construct a building, purchase a computer and so on). In addition, the very nature of the business required that stock be ordered six months in advance. Because of the competition, he had to pay suppliers on a short-term basis. Finally, in a business of this kind, something as simple as the late arrival of spring can sometimes delay receipts and also payments to the bank.

3.06 Moreover, the financial institution required additional security in order to extend the line of credit. The physical assets of the business had a lower value than its debts, although the latter may have been less than potential assets. Moreover, as Mr Réal Côté was the prime mover in the business, the latter would come to a halt in the event of his death. Finally, the business did not have a high enough net profit margin. The financial institution required as the best security, in addition to Mr Côté’s personal endorsement, an interim debt certificate, namely a lien on all present and future property of the company, including accounts receivable.

3.07 As the interim debt certificate could not be obtained because of certain technical details (in fact, it was not obtained until the end of 1976), the banking institution then required a temporary life insurance policy of $1,000,000 on Mr Cote’s life. The banking institution was to be named the beneficiary up to the amount of the debt.

3.08 The appellant then obtained not only a $1,000,000 policy (Exhibit 1-1) but also a $500,000 policy (Exhibit 1-2), in anticipation of future credit that might be required, and because of the reduction in the regular value of the policy. Moreover, the cost of policies in 1975 was less than it would have been in succeeding years because of Mr Côté’s age, which naturally constituted a greater risk. It was even to be anticipated that Mr Côté might become uninsurable in later years.

3.09 In 1975, the two premiums cost $7,575 and in 1976 $7,790. The appellant filed its tax returns for these years and claimed these amounts as expenses.

3.10 The facts summarized in paragraphs 3.04 to 3.10 were dealt with in testimony by the appellant—by its accountant Mr Morin—and this was confirmed by letters written by BCN, the appellant’s banking institution, Exhibits A-1 and I-4.

3.11 After the hearing, that is at the beginning of the argument, the parties Stated that they were in agreement on the following point: if the action is allowed, the amounts deductible will be $2,977 in 1975 and $2,388 in 1976. This agreement was based principally on the cost of the premium for the $1,000,000 policy and the maximum credit line for each year: 1975 ($615,400) and 1976 ($453,000).

4. Act—Case Law—Comments

4.1 Act

The principal sections in question here are paragraphs 18(1)(a), 18(1)(b) and subparagraph 20(1)(e)(ii) of the new Income Tax Act. These sections read as follows:

18.(1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property;

(b) an outlay, loss or replacement of capital, a payment on account of capital or an allowance in respect of depreciation, obsolescence or depletion except as expressly permitted by this Part;

20.(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:

(e) an expense incurred in the year,

(ii) in the course of borrowing money used by the taxpayer for the purpose of earning income from a business or property (other than money used by the taxpayer for the purpose of acquiring property the income from which would be exempt),

4.2 Case Law

The case law cited by the parties is:

1. Bennett and White Construction Co Ltd v MNR, [1949] CTC 1; 49 DTC 514;

2. British Columbia Electric Railway Company Limited v MNR, [1958] CTC 21; 58 DTC 1022;

3. Equitable Acceptance Corp Ltd v MNR, [1964] CTC 74; 64 DTC 5045;

4. Montreal Coke & Manufacturing Co v MNR, [1944] CTC 94; 2 DTC 535;

5. Neonex International Ltd v Her Majesty the Queen, [1978] CTC 485; 78 DTC 6339;

6. Riviera Hotel Co Ltd v MNR, [1972] CTC 157; 72 DTC 6142;

7. Pau I-Em He Deschenes v MNR, [1979] CTC 2690; 79 DTC 461;

8. Rousseau Metal Inc v MNR, [1979] CTC 2681; 79 DTC 467.

4.3 Comments

4.3.1 Is paragraph 18(1)(a) applicable?

The evidence showed that the increase in the line of credit was necessary primarily to construct a building and purchase a computer. The increased line of credit used for these purposes constituted an increase in the capital of the company. Any payment made in order to obtain capital is covered by paragraph 18(1)(b) cited above, not paragraph 18(1 )(a).

Consequently, the expenditure made to pay an insurance premium guaranteeing the increase in the said line of credit cannot be deducted under paragraph 18(1)(a).

However, the Board is inclined to think that if the increased line of credit had not been used only for current expenses of the company and in the form of a temporary loan, the premium paid on a life insurance policy to guarantee that loan would be deductible under paragraph 18(1 )(a).

In the case at bar, therefore, only one section remains under which the said premium could be deductible. This is subparagraph 20(1 )(e)(ii).

4.3.2 Is subparagraph 20(1 )(e)(ii) applicable?

4.3.2.1 Preliminary condition of subsection 20(1)

First, the evidence established that the condition set forth in the preamble of subsection 20(1), which is a preliminary condition of all the succeeding paragraphs, namely paragraph 20(1)(a) to paragraph 20(1)(f), was met. This condition is that in computing the income from a business or property the sum indicated in the various paragraphs, which may be deducted, is that relating entirely to the source of income.

In the case at bar, the expense was claimed in computing the income in the appellant’s financial year. The loan was made for the purpose of the business. The payment of premiums was in order to guarantee the loan.

It might have been difficult if the appellant, having two separate businesses, had tried to deduct the insurance premium in computing the income of A—when the loan had been made for business B, which had made no income in that year.

In Paul-Emile Deschenes v MNR, cited above, the Board based a judgment to this effect, denying an interest charge and the expense of payment of an insurance policy premium because the appellant sought to deduct, against his income for 1973, the foregoing expenses applicable to business which had been transacted in 1970 but on which the appellant still had to pay interest on the debts and insurance policy premiums guaranteeing the debt.

The Board then cited Jackett, J in Trans-Prairie Pipelines Ltd v MNR, [1970] CTC 537; 70 DTC 6351.

4.3.2.2 The condition of subparagraph 20(1)(e)(ii)

The respondent cited certain cases which are worth examining.

1. In Bennett and White, the Supreme Court upheld a judgment of the Exchequer Court, disallowing commissions paid to directors of a company for guaranteeing the debt of the said company to the bank. The Courts relied on paragraph 6(1 )(a) of the Income Tax Act, the present paragraph 18(1)(a). At that time, there was not equivalent of paragraph 20(1)(e). The years involved in this case were 1941 and 1942. An equivalent of paragraph 20(1)(e) appeared in the Act in 1955; at that time it was paragraph 11(1)(b) of the preceding Act. However, the Supreme Court ruled that the commissions paid were expenses incurred to obtain capital in order to finance the appellant’s operations. Such an expense is now deductible in accordance with paragraph 20(1)(e), “notwithstanding the provisions of paragraphs 18(1 )(a), (b) and (h).. .”’, as provided in the preamble of section 20. It is on account of the absence of a provision authorizing such an expense and judgments resulting from this that, for obvious reasons of economic stimulus, the legislator in 1955 introduced paragraph 11(1)(cb) into the old Act.

2. The case of British Columbia Electric Railway Co Ltd [supra] is not as relevant, because the judgment rendered related to the years 1933 to 1941, that is before the equivalent of paragraph 20(1)(e) was introduced in 1955. An expenditure made in order to eliminate a competitor was held not to be deductible as an expense because of the existence of the equivalent of paragraph 18(1)(a).

3. The same comments may be made mutatis mutandis concerning Montreal Coke & Manufacturing Co, [supra] in which the year involved was 1935. Expenses for the issuing of bonds were disallowed.

4. In Neonex International Ltd, [supra] decided in 1978 by the Federal Court of Appeal, it was held that a bond paid to an insurance company in order to obtain discharge from a debt and borrow a larger amount from another lender was not deductible under subparagraph 20(1 )(e)(ii). The expense was not regarded as “incurred in the year. . . in the course of borrowing money’’, but as resulting from the payment of money borrowed from a prior lender. Accordingly, it did not fall squarely within the conditions of the exempting subparagraph 20(1 )(e)(ii). The Court relied on the decision in Riviera Hotel Co Ltd [supra].

5. However, Equitable Acceptance Corp Ltd, [supra] decided in 1964, is more appropriate. The appellant claimed for 1955 and 1956 the cost of life insurance premiums paid on the principal shareholder of the company to secure a bank loan, a security required by the bank as in the case at bar.

Cattanach, J disallowed the expense. He said:

The evidence clearly established that the money borrowed by the appellant from Triarch was forthwith deposited in the appellant’s bank account and was used in the operation of the appellant’s business. The loan was not comparable to mere temporary accommodation from the appellant’s bankers, but was rather an addition to the capital of the appellant.

Any payments for the purpose of obtaining capital are outlays of capital within the meaning of section 12(1)(b).

Therefore, it is quite clear that payment of premiums on the life insurance policies is not deductible unless it falls within the express terms of section 11 (1 )(cb)(ii) of the Act and the issue for determination is whether the said payment of the life insurance premiums constituted an expense incurred in the year in the course of borrowing money.

Section 11(1)(cb) was enacted by section 1(1) of chapter 54, Statutes of 1954-5 and made applicable to the 1955 and subsequent taxation years and enables the deduction of expenses normally incurred in raising funds by borrowing which were not previously deductible because they were not directly related to the earning of income and were of a capital nature.

In my view the cost of the purchase of the two life insurance policies and the maintenance in force thereof by the payment of premiums is not an expense incurred in the year in the course of borrowing money used by the taxpayer for the purpose of earning income from a business. While it is true that the purchase of these life insurance policies and their assignment to Triarch was a condition imposed by Triarch before making the loan to the appellant, nevertheless the true nature of the transaction was that the appellant acquired an asset which could be used, and was in fact used, as a collateral security necessary to borrow money to be used in its business. In short, the appellant, by the purchase of the two insurance policies, merely enhanced its position as a reliable lending risk.

If the insured, Emil E Schlesinger, had died while the policies were in force and before the repayment of the loan, the appellant would then be in the position of the loan being fully paid from the proceeds of the insurance policies and the amount of the loan received by the appellant would become part of the appellant’s assets without any corresponding debit entry. Again if the proceeds were in excess of the amount required to repay the loan, then any such excess would have accrued to the appellant’s assets. Further when the loan was repaid, as it was, there was nothing to prevent the appellant from securing another loan from the same or a different source on the strength of the security of the two life insurance policies, if the necessity arose.

The Board does not entirely agree with the reasons for this judgment.

In the Board’s opinion, the payment of insurance policy premiums complies word for word with the condition specified by subparagraph 20( I)(e)(ii), namely that the expense was incurred “dans l’année à l’occasion d’un emprunt contracté par le contribuable et utilisé en vue de tirer un revenu d’une entreprise ou de bien ..

It is worth citing the English wording:

(e) an expense incurred in the year,

(ii) in the course of borrowing money used by the taxpayer for the purpose of earning income from a business or property . . .

The phrase “in the course of’’ may appear at first sight to have a more limited meaning than “à l’occasion de”. In 1974, however, ten years after the Equitable Acceptance Corp Ltd judgment [supra], in Yonge-Fqlinton Building Ltd v MNR, [1974] CTC 209; 74 DTC 6180, the Federal Cour. of Appeal, per Thurlow, J, explained the meaning of “in the course of”, and appeared to give it a rather broad meaning, as least as broad as “à l’occasion de”:

It may not always be easy to decide whether an expense has so arisen but it seems to me that the words “in the course of’’ in section 11(1)(cb) are not a reference to the time when the expenses are incurred but are used in the sense of “in connection with” or “incidental to” or “arising from” and refer to the process of carrying out or the things which must be undertaken to carry out the issuing or selling or borrowing for or in connection with which the expenses are incurred.

French translation:

Il se peut qu’il ne soit pas toujours facile de décider si une dépense résulte de telles circonstances, mais il me semble que l’expression ‘à l’occasion de’ à l’article 11(1)(cb) ne se rapporte pas à l’époque où les dépenses ont été engagées; elle est utilisée dans le sens de ‘relativement à’, ‘résultant de’ ou ‘imputable à’ et se rapporte au mode d’exécution ou à ce qui doit être fait pour réaliser l’émission ou la vente ou l’emprunt pour lesquels ou relativement auxquels les dépenses ont été engagées.

Although the Court made this comment in a discussion of time, the broad meaning given to the phrase “in the course of’’, is still valid. When the appellant purchased its two insurance policies to guarantee the loan (a condition required by the lender), it did so “in the course of borrowing money” although, as Cattanach, J observed, in doing so the appellant “merely enhanced its position as a reliable lending risk”.

The Board considers that even if the insured died and the appellant, after receiving the indemnity and paying the balance owed the lender, still had a substantial amount in its bank account, that does not alter the fact that the payment of the premiums, at least in the earlier years, was made “in the course of borrowing money”. It appears to the Board that once the situation falls word for word within the Act, particularly in an exempting section, there is no need to look for hypothetical consequences which might be more favourable to the taxpayer, and then if any are found, disallow the exemption. The phrases ‘‘a l’occasion de” or “in the course of”, in the broad meaning given them by the Federal Court of Appeal, do not allow of such a restrictive interpretation.

Ordinarily, the Board is bound by a judgment of the Federal Court. However, because of the decision of the Federal Court of Appeal cited above, the Board feels it is justified in giving the section the meaning discussed above and so allowing the appeal.

5. Conclusion

The appeal is allowed and the matter referred back to the respondent for reassessment in accordance with the foregoing reasons for judgment.

Appeal allowed.