Call Holdings Limited v. Minister of National Revenue, [1977] CTC 2390, 77 DTC 288

A J Frost:—This is an income tax appeal from assessments for the appellant’s 1969, 1970, 1971 and 1972 taxation years, wherein amounts of interest claimed by the appellant as deductions from income were not allowed on the ground that the interest disbursed was not interest on borrowed money used for the purpose of earning income within the meaning of the Income Tax Act.

In 1966 the appellant company built an industrial building at 100 Fenmar Drive, Weston, Ontario at a cost of $81,783. The building was partly financed by a first mortgage and other credits.

In 1967, 1968 and 1969 the appellant borrowed, on the security of a second mortgage, the sum of $30,000 from Smith & Gibbons and $25,000 from Egret Acceptance Corporation to finance further projects of two associated companies—Marcall Construction Limited (Marcall) and Gorell Investments Limited (Gorell), controlled by the Calligaro family.

As at December 31, 1969 these liabilities were on the books of the appellant as follows:

The members of the Calligaro family were not sophisticated businessmen and did not get proper professional advice. They did agree among themselves that interest would be paid on the advances made to the two associated companies, Marcall and Gorell.

The projects undertaken by Marcall and Gorell started to go “sour” in 1968 and the advances made were finally written off as losses in 1970 and 1971.

In 1970 the loan liabilities were re-financed by borrowings from Colin Watson in the amount of $15,000 and Credit Foncier in the amount of $85,000. The sums owed were used to pay off the existing liabilities originally incurred in the financing of ill-fated projects and the surplus was used for general corporate purposes.

The Minister disallowed the interest claimed on that part of the funds borrowed to discharge previous liabilities and not to earn income.

There are two questions at issue in this appeal:

1. Were the original advances made to Marcall and Gorell interestbearing investments?

2. Did the subsequent re-financing by the appellant company alter the appellant’s tax position?

With respect to the first question, it was established in evidence that:

(a) In July 1967 two amounts totalling $2,100 were paid in cash to cover interest owing by Marcall.

(b) An accrued interest item in the amount of $2,000 was established in the Call Holdings journal and posted to the respective ledger accounts as of December 31, 1969. This entry was recorded in reverse to what it should have been, but the purpose of the entry is clear and unequivocal, and established in my opinion an intention to charge interest with respect to amounts owing by Gorell.

These two bookkeeping entries supported the sworn testimony of Mr Alfonso Calligaro indicating that the moneys originally borrowed by the appellant were, in fact, used for the purpose of earning income.

The second part of the question at issue is: Can a taxpayer exchange one liability for another without altering his tax position?

Counsel for the Minister, in his argument, submitted that that part of the funds borrowed in the second re-financing to pay off the Smith & Gibbons loan was not used to earn income, but to discharge an existing liability. He submitted that once funds invested ‘‘are gone” the appellant cannot continue to deduct interest on the borrowed Capital despite the fact that the first use of the borrowed funds was in the business of the appellant.

In my opinion, Trans-Prairie Pipelines Ltd v MNR, [1970] CTC 537; 70 DTC 6351, stands for the proposition that once the first use of funds is established, a subsequent exchange of liabilities does not alter the taxpayer’s position. It was easy enough in the instant case, as it was in the Trans-Prairie Pipelines Ltd case, to trace the flow of funds through the corporate accounts and for the Minister to advise the Court as to the disposition of those funds. In many instances, however, such a tracing is virtually impossible as it could involve many hundreds of individual transactions affecting the credit position of the appellant company and the general use of funds in the business. Therefore, as a matter of business common sense, it seems to me that once the first use of funds is established the flow of funds through the corporate accounts of the appellant cannot affect the taxpayer’s legal position.

In the case at bar, the two daughter companies failed and the loss is a capital loss which must be charged against the surplus account. This, however, is not the point at issue. The financing for the daughter companies had been arranged before the loss was incurred. The liability which related to these bad investments was re-financed by a new loan. If the interest on the old loan is a deductible expense, the interest on the new loan stands in precisely the same position. It does not make business sense to conclude that the shifting of the debt structure of a corporation alters its taxable position. A rearrangement of credits per se cannot be taken as prejudicially affecting a taxpayer’s liability to pay taxes on income.

The appeal is therefore allowed and the matter referred back to the respondent for reconsideration and reassessment accordingly.

Appeal allowed.