John R. Singleton v. Her Majesty the Queen, [1996] 3 CTC 2873

Bowman J.T.C.C.: — These appeals from assessments for 1988 and 1989 involve a question of the deductibility of $3,688.52 and $27,915.46 in interest on a loan of $300,000.00. In brief the appellant contends that the borrowed money was used to contribute capital to the law firm of which the appellant was a partner, whereas the respondent says it was used to finance the purchase of a house bought by the appellant’s wife.

The case was originally heard by Judge Kempo of this court. Judge Kempo retired before she was able to render judgment and, with the consent of both parties, the matter was reargued before me on the basis of the transcript.

In 1988 and 1989, the appellant was the senior partner of a Vancouver law firm, Singleton Urquhart. The fiscal year end of the partnership was January 31. On October 27, 1988 the balance standing to the appellant’s credit as his share of the capital account of the partnership was at least $300,000.00*.

On that day, October 27, 1988, the following events occurred:

1. $400,000.00 was borrowed from the Bank of British Columbia by the appellant’s wife. A mortgage was put on the house and the appellant signed the mortgage as covenantor. It is clear that the appellant had a legal obligation to pay principal and interest on the loan not as guarantor but as principal obligor.

2. A client trust account was opened by the partnership for the purpose of handling funds that were to be used to buy a residential property in Vancouver for the appellant and his wife. Title was to be taken in the name of the appellant’s wife, Joanne.

3. $300,000.00 was paid into the partnership pooled trust account and was then paid by cheque to the partnership general account and credited to the appellant’s capital account. The payments by the appellant to the partnership of $300,000.00 were made to the extent of $1,250.00 by the appellant and to the extent of $298,750.00 directly from the Bank of British Columbia.

4. The partnership paid $300,000 to the appellant and he deposited this amount in his personal account at the Bank of Montreal.

5. The appellant issued a cheque drawn on his personal account at the Bank of Montreal in the amount of $300,000.00 which was payable to the partnership and that amount was deposited to the client trust account. The appellant’s spouse deposited $147,901.00 to the same account.

6. The partnership issued a cheque for $440,451.00 drawn on the client trust account and payable to the solicitors for the vendors of the house that the appellant’s wife was buying, to complete the purchase.

All of the above happened on October 27, 1988 and the appellant’s capital account was the same after the sequence of steps as before.

The appellant seeks to deduct in computing income the interest on the $300,000.00 portion of the $400,000.00 borrowed from the Bank of British

’There was initially some uncertainty about this but it was finally admitted by the respondent. The exact composition of the capital account of the partnership was not made clear in the evidence. The expression “capital account” appears to be one of some elasticity. As a practical matter, the capital account of a professional partnership would normally include the original contributions by the partners used to acquire fixed assets, and through the firm’s general account, to provide working capital. It could include accounts receivable less a reserve for doubtful accounts, and, in some cases, possibly work-in-progress. I do not intend this to be a comprehensive definition and no expert accounting evidence was given. Depending upon the conservatism of the accounting practices adopted, it could cover the entire equity of the owners, or it could be limited to only that portion considered to be permanent. It could also include only that portion of the profit and loss account that is transferred at the end of an accounting period to the capital account. In light of the admission I need not assign a precise definition to the term, but will, for the purposes of this case, treat the capital account as being, in essence, the assets of the firm net of its liabilities.

Columbia.

There is no evidence that the partnership had sufficient cash to make a distribution of capital to the appellant of $300,000.00 were it not for the infusion of the same amount by him on the same day. It would be improbable, indeed surprising, for a small two person law firm to have $300,000.00 lying in its bank account waiting to be distributed.

Any analysis of the matter must start (and, indeed, end) with the question, what was the $300,000.00 that was borrowed from the Bank of British Columbia used for? Paragraph 20(1 )(c) of the Income Tax Act permits the deduction of

an amount paid in the year or payable in respect of the year ..., pursuant to a legal obligation to pay interest on

(i) borrowed money used for the purpose of earning income from a business or property ...

It should be observed that words are “used for the purpose of’ not “borrowed for the purpose of...”.

Obviously, a contribution of capital to one’s law firm would normally be an eligible use of borrowed funds for the purpose of paragraph 20(1 )(c) where the money is in fact used in the firm’s business, whereas the purchase of a personal residence would not be.

What happened on October 27, 1988 is that money came from the bank, went through the firm and immediately went out to the appellant and was used in the purchase of the house. Without suggesting that there was any sham or dissimulation, that is the reality of the situation. Mr. Justice Judson speaking for the Supreme Court of Canada, said in Minister of National Revenue v. Cox (sub nom. Cox Estate v. Minister of National Revenue), [1971] S.C.R. 817, [1971] C.T.C. 227, 71 D.T.C. 5150, at page 820 (C.T.C. 229; D.T.C. 5151):

I am in complete agreement with the Minister’s contention that the exchange of cheques was merely the machinery used to effect a gift of the policy by the deceased to his wife. The simultaneous exchange of cheques where neither would be honoured due to insufficient funds were it not for the offsetting entry of the other cheque, can only be viewed as a single transaction. In substance, the deceased transferred to his wife the policy of life assurance plus the exact amount of the next year’s premium, the sum of $1,526.50, being the difference between $6,076.50 and $4,550.00

On any realistic view of the matter it could not be said that the money was used for the purpose of making a contribution of capital to the partnership. The fundamental purpose was the purchase of a house and this purpose cannot be altered by the shuffle of cheques that took place on October 27, 1988.

Counsel for both parties referred at length to Bronfman Trust v. R. (sub nom. Bronfman Trust v. The Queen), [1987] 1 S.C.R. 32, [1987] 1 C.T.C. 117, 87 D.T.C. 5059. That case contains many wide-ranging obiter dicta on a variety of aspects of interest deductibility, but its ratio decidendi is relatively narrow. It stands for what I should have thought was the self- evident proposition that interest on money borrowed by a trust to make a distribution of capital to a beneficiary is not deductible under paragraph 20(1)(c). Both counsel found obiter dicta in the reasons for judgment of Dickson C.J. that appeared to support their respective positions but the answer I think is to be found in the plain words of paragraph 20(1 )(c). Money borrowed by a partner of a law firm that is initially put into the firm but in fact immediately paid out to him to fund the purchase of a house is used as a matter of economic reality for the purpose of buying a house. It is irrelevant in what order the sequence of events took place. The borrowing, the distribution of money to one partner, the repayment of the amount by the partner to replenish his momentarily depleted share of the capital account and the purchase of a house — all were conterminous and interdependent.

The true purpose of the use of the borrowed funds subsumed the subordinate and incidental links in the chain. Theoretically one might, in a connected series of events leading to a predetermined conclusion, postulate as the purpose of each event in the sequence the achievement of the result that immediately follows but in determining the “purpose” of the use of borrowed funds within the meaning of paragraph 20(1 )(c) the court is faced with practical considerations with which the pure theorist is not concerned.

The appellant here relies as well upon the decision of the Exchequer Court in Trans-Prairie Pipelines Ltd. v. Minister of National Revenue, [1970] C.T.C. 537, 70 D.T.C. 6351. That case dealt with a company that redeemed its preferred shares for $700,000 in order to raise further capital by means of bond issues. The company then borrowed $700,000 by way of a bond issue and raised a further $300,000 by issuing additional common shares. In order to redeem the preferred shares, $300,000 came from the new issue of common shares and $400,000 came from the new bond issue. The issue was whether the interest payable on the bonds was deductible by reason of paragraph 1 l(l)(c) (now paragraph 20(1 )(c)). The Minister allowed a deduction for interest only on the $300,000 portion, on the basis that the remainder was not used for the purpose of earning income. The court held that the whole of the borrowed money was used for the purpose of earning income since it went to fill the gap left by the redemption. The court also held that what is important in such matters is not whether the funds are still being used for the original purpose for which they were borrowed, but whether they are being used in the present taxation year in order to earn income.

The correctness of Trans-Prairie Pipelines has not been explicitly questioned, but the decision has been confined to its own special circumstances; (Bronfman Trust (supra) at pages 52-55 (C.T.C. 128-29; D.T.C. 5067); Attaie v. Minister of National Revenue (sub nom. The Queen v. Attaie) (sub nom. R. v. Attaie), [1990] 2 C.T.C. 157, 90 D.T.C. 6413 (F.C.A.); Livingston International Inc. v. Minister of National Revenue (sub nom. Livingston International Inc. v. Canada), [1992] 1 C.T.C. 217 (sub nom. Livingston International Inc. v. R.), 91 D.T.C. 5066 (F.C.A.); Sternthal v. R. (sub nom. Sternthal v. The Queen), [1974] C.T.C. 851, 74 D.T.C. 6646 (F.C.T.D.); WP Graphics Inc. v. R., [1996] 2 C.T.C. 2333 (T.C.C.). Trans-Prairie Pipelines appears to have no application where a partner of a law firm borrows money which he or she simultaneously contributes to and withdraws from the firm and uses to purchase a house. In such a case it would be unreasonable to suggest that the funds realistically can be traced to an income earning use. Rather, they ended up in the purchase of the house, even though they arrived there after a brief detour through the firm’s accounts. Although the principle is substantially the same the matter is put into even sharper focus if one presupposes the case of a sole practitioner who needs money to buy a personal residence. If he or she borrows money and uses it to buy the house the interest is obviously not deductible. If the money is in effect routed through the practice as a contribution of capital followed immediately by a payment back to the practitioner as a payment of capital, leaving the capital account unchanged, commercial common sense would tell one that the money was used to buy the house, not to enhance the income producing potential of the practice.

Counsel for the appellant also referred to the decision of the Supreme Court of Canada in Mara Properties Ltd. v. R. (sub nom. R. v. Mara Properties Ltd.), [1996] 2 S.C.R. 161, [1996] 2 C.T.C. 54, 96 D.T.C. 6309. That case involved the acquisition by a corporate taxpayer of the shares of a company which held property on revenue account that, if sold, would give rise to an income loss. After the acquisition of the company it was wound up, the property was sold, and the resulting loss claimed as a deduction in computing the taxpayer’s income. Judge Kempo, whose judgment was affirmed by the Supreme Court of Canada, allowed the appeal and held that the property retained its quality of inventory. I do not think that the case assists in answering the factual question with which I am faced here, the purpose for which the funds were used. Counsel observed that in Mara the series of prearranged transactions was carried out on the same day with purely tax considerations in mind. He submits that the same reasoning should apply here, and that “once the validity of the transaction is accepted it follows that the borrowed money was used only for the purpose of earning income from the appellant’s firm.” This, however, is not determinative of the matter. I do not base my decision on the admitted tax objective that the appellant sought to achieve by the manner in which the transaction was structured, nor do I suggest that the “substance” differed from the “form”, or that any of the steps were legally invalid. Such questions do not arise, the only question being the purpose for which the funds were used. In that determination, at least in this case, any attempt to apply the concept of substance over form merely muddies the waters. What the appellant purported to do, he did. I am basing my decision on the fact that, even if one accepts the legal validity of the steps that were taken and also treats the obvious tax motivation as irrelevant, one is still left with the inescapable factual determination that the true economic purpose for which the borrowed money was used was the purchase of a house, not the en- hancement of the firm’s income earning potential by a contribution of capital. Despite the skill with which the argument was presented, I cannot accept that the fleeting passage of the borrowed money through the accounts of the law firm serves as a permanent identification of its use.

The appeals are dismissed with costs.

Appeal dismissed.