Chase Manhattan Bank of Canada v. R., [1997] 2 CTC 3097, 97 DTC 349

McArthur T.CJ.:

These appeals are from assessments of the Appellant’s 1987 and 1988 taxation years. The Chemical Bank of Canada changed its name to The Chase Manhattan Bank of Canada (the “Bank”). The Bank was sole shareholder of the Chemical Bank of Canada Leasing Limited (“Leasing”) which has been dissolved. The issue is the deductibility of interest on loans, the proceeds of which were used by Leasing to pay dividends to the Bank.

The facts, as contained in an Agreed Statement of Facts and as found by me, include the following: Leasing, a Canadian Corporation was 100% owned by Chemical Bank of Canada. Leasing was in the business of financing equipment, such as an aircraft and leasing it to a commercial operator. Its assets and liabilities were transferred to the Bank on a voluntary winding up on September 29, 1988. The Bank loaned approximately $37,000,000, to Leasing, payable with interest, to finance Leasing’s operations from 1982 to 1986. For tax purposes, this structure was changed in February 1986, when the Bank subscribed for additional share capital of Leasing and paid for by offsetting an indebtedness of $37,100,000 then owing to it by Leasing. Sub- sequently, the Bank suffered losses and wished to revert to its original position.

Mr. J.A. Essex, a director of Leasing and the Bank during the relevant period was the only witness to testify. He stated that Leasing could effectively defer the payment of income tax by claiming capital cost allowance on the equipment it owned and leased. A memorandum dated March 3, 1987 was sent by Mr. Essex to Mr. W.T. Upson, President of the Bank and others, advising them that he had received an opinion from their solicitors affirming the directors’ decision to pay a $45,000,000 dividend to the parent company, the Bank. The second sentence of the memorandum stated: “The rationale for this move is that CBOC (Bank) can better utilize the funds, from a tax perspective, than can CBCLL (Leasing). The dividend will flow tax-free to CBOC (Bank)”. He wrote further in April 1987:

More recently CBOC (the Bank) has experienced some losses which preclude the need to utilize this tax deferring technique. Since CBCLL (Leasing) can delay the use of its tax deferrals, the most logical approach is to repatriate the cash invested back to CBOC. The repatriation can take the form of a tax free dividend to (the Bank) according to our legal counsel.

By written resolution dated August 4, 1987 the directors of Leasing resolved that Leasing pay to its sole shareholder a cash dividend of $45,000,000. The dividend was paid with $36,000,000 borrowed from the Bank and the balance in cash from Leasing’s operations. The interest charged by the Bank on the borrowed money and expensed by Leasing was $802,446.79 for the period August 1987 to October 31, 1987, and $2,910,000 for the period November 1, 1987 to September 29, 1988. Leasing had paid no prior dividends to the Bank. This dividend repaid most of the Bank’s capital interest in Leasing. The Bank reported the interest income charged to Leasing in respect of the $36,000,000 borrowing. The Bank also reported the $45,000,000 dividend and deducted it under section 112 of the Income Tax Act (the “Act”) as a tax-free intercorporate dividend.

The 1987 and 1988 taxation years of Leasing were reassessed on June 13, 1993 to disallow the interest expense claimed of $802,447 in 1987 and $2,910,000 in 1988. Pursuant to a redetermination of loss for 1987 and further reassessment for 1988 both issued March 21, 1995 interest expense in the amount of $120,801 for 1987 and $438,074 for 1988 was allowed. The disallowed interest expense therefore at issue in these appeals is the amount of $681,646 for 1987 and $2,471,925 for 1988. The quantum of interest expense is not in dispute. (In essence, Revenue Canada allowed the interest on the amount of Leasing’s retained earnings).

Position of the Appellant

Interest expense on borrowed money used by a corporation to replace capital which was used in the business, but which was distributed to a shareholder of the corporation, is deductible since such funds are borrowed for the purpose of earning income. In order to determine what capital was used in the business immediately prior to a distribution, the courts have taken a common sense approach and looked at the share capital and retained earnings of the corporation. The underlying principle applied by the courts, however, does not depend on a precise categorization of the method of distribution and the various shareholders equity accounts, but on whether the corporation has truly distributed capital used in its business to its shareholder, and whether this distributed capital has been replaced by the borrowing.

Counsel urged the Court to follow the decision of Jackett P. in TransPrairie Pipelines Ltd. v. Minister of National Revenue, (1970), 70 D.T.C. 6351 (Can. Ex. Ct.) (Trans-Prairie). He stated that while the direct use of the funds received by Leasing was to pay a dividend, the funds replaced the original funds advanced by the Bank. The practical nature of the transactions was to refinance the capital used in Leasing’s business. The fact that the distribution of capital took the juristic form of a dividend does not change the fact that Leasing was deprived of the capital necessary to its business by virtue of the distribution to the Bank, and had to borrow to replace the capital which had been financing its leasing activities.

The true commercial purpose of the use of the borrowed funds from the Bank was to refinance the assets of Leasing. This refinancing was necessary due to the virtually simultaneous distribution of capital to the Bank. When Leasing’s situation is viewed practically and with “business common sense” using the approach adopted in Trans-Prairie (supra), Bronfman Trust v. R., (1987), 87 D.T.C. 5059 (S.C.C.) and Mark Resources Inc. v. R., (1993), 93 D.T.C. 1004 (T.C.C.), it is clear that the funds borrowed by Leasing should be regarded as having been used to earn income.

Position of the Respondent

The $36,000,000 borrowed by the Appellant was used immediately to pay a $45,000,000 dividend. It was never used to earn income. The Appellant does not meet the exception in Trans-Prairie where there was liquidation of assets or actual reduction of share capital.

Counsel added that in Trans-Prairie there was an actual redemption of the preferred shares leaving a real “hole” to fill. By filling that hole Trans- Prairie received an additional $300,000 working capital. Leasing did not receive any additional funds.

Analysis

Paragraph 20(l)(c) of the Income Tax Act (the “Acf’) 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 borrowed money used for the purpose of earning income from a business or property. Had the money been in fact directly used in Leasing’s business the interest would be deductible.

The direct use of the $36,000,000 borrowed by Leasing from the Bank was to pay the lender a dividend. This is an ineligible use. No additional funds were received by Leasing to be used for the purpose of earning income as was the case in Trans-Prairie.

In Trans-Prairie the corporate taxpayer wanted to raise funds to expand its business. It could not float a bond issue unless it redeemed its preferred shares. It borrowed $700,000. The sum of $400,000 was used to redeem the shares and the remaining $300,000 was used to expand its business. President Jackett, as he then was, held that interest payments on the entire $700,000 were deductible. He viewed the borrowed funds as “fill[ing] the hole left by redemption....” (at 541).

Counsel for the Appellant presented that the principle in Trans-Prairie applies. Because the original funds were used for the purpose of earning income, the interest paid on the amount borrowed to redeem the preferred shares was also deductible. Since that decision, it would appear that Revenue Canada allows the deductibility of interest on borrowed money used to redeem shares or to pay dividends, to the extent that a corporation has accumulated profits. The Minister has applied this approach to the Appellant. Counsel for the Appellant submitted that the Trans-Prairie principle applied to the remainder of the borrowed money. He asks the Court to extend the Trans-Prairie principle to apply to paid up capital and the entire net value of the company’s assets.

Given the decision in Bronfman and more recent cases, I find that the Trans-Prairie decision cannot be extended that far. Both counsel referred to the Bronfman decision in which Trans-Prairie was dealt with at length. It was not disapproved of but it would appear that the Supreme Court would not extend application of Trans-Prairie beyond what the Minister has allowed the Bank.

In Livingston International Inc. v. Minister of National Revenue, (1990), 91 D.T.C. 5066 (Fed. T.D.), at 506and 5070, Pinard J. stated:

In light of the Bronfman Trust decision, it would seem to me that one cannot infer from the Trans-Prairie case that interest on borrowed money used to redeem shares is generally deductible.

...where it cannot really be said that the borrowed funds are used to fill a hole left by the “withdrawal” of funds previously used in the borrower’s business, it is rather doubtful that the Trans-Prairie reasoning can be applied....

In the recent decision by the Federal Court of Appeal in 74712 Alberta Ltd. v. R. (January 29, 1997), Doc. A-434-94 (Fed. C.A.) (not yet published), Robertson J.A. dealt extensively with the Bronfman decision. While they arrive at the same conclusion, Linden J.A. wrote the majority judgment (Robertson J.A.’s decision must be considered obiter dicta). He stated at page 13:

In certain circumstances interest payments may be deducted even though they are tied to a direct ineligible use of borrowed funds. In support of that conclusion I offer four reasons. Summarily stated, they are as follows:

First, the exception category accords with the object and purpose of paragraph 20(l)(c)(i). Second, recognition of the exceptional category does not negate the policy objective underlying the existence of the direct-use rule. Third, the Supreme Court in Bronfman did not expressly overrule Trans-Prairie Pipelines Ltd. v. M.N.R., [1970] C.T.C. 537 (Ex. Ct.). In that case it was held that the taxpayer could deduct from income interest payments on funds borrowed for what may be regarded as an indirect eligible use. Fourth, the exceptional category accords with the directive found in Bronfman that transactions be viewed with an eye to “commercial realities

He continues at page 18:

Few tax cases are argued in this Court which do not begin with a reminder that the Court must have regard to the true commercial and practical nature of the taxpayer’s transactions. All must be assessed with an eye to commercial and economic realities.

With this background, I refer to the present context. Leasing did not have $36,000,000 to pay the dividend. The borrowed money was used to pay this portion of the dividend. The direct purpose of the borrowing was motivated by the Bank’s desire to minimize or avoid the payment of income tax. That was the commercial and practical nature of the transactions. The direct use of the borrowed funds, that is the payment of dividends to the borrower, was not an eligible use. The true purpose of the loan was to have Leasing, who was in the position to defer taxes, pay interest to the Bank that had suffered losses.

The Appellant relies heavily, if not exclusively, on coming within the exception to paragraph 20(1)(c) of the Act as found in Trans-Prairie. While Trans-Prairie is still good law, it has been confined to its own special circumstances (See Bronfman (supra), Livingston (supra) and 74712 Alberta Ltd. (supra). Trans-Prairie does not apply where a company borrows money which it simultaneously contributes to and withdraws from the company and uses it to pay a dividend to the lender. It is unreasonable, under these circumstances, to find that the funds can be traced to an income earning use. The borrowed funds were not used to fill a real hole but instead were used to pay a dividend. The purpose of the loan was to reduce Leasing’s taxable income by paying interest to the Bank which was in a loss position. No additional capital was added to enhance Leasing’s earnings.

The appeals are dismissed with costs.

Appeal dismissed.