Distillers Corporation Limited v. Minister of National Revenue, [1974] CTC 2258, 74 DTC 1197

The Assistant Chairman:—This is the appeal of Distillers Corporation Limited from income tax assessments dated February 6, 1973 in respect of the 1967, 1968 and 1969 taxation years.

By notice of appeal dated November 26, 1973 the appellant company appealed from the said assessments whereby the Minister of National Revenue had disallowed the deduction of the following amounts paid as interest on money borrowed from Gulfstream Insurance Limited, a company incorporated in the Bahamas, and in the relevant years a wholly-owned subsidiary of Distillers Corporation- Seagrams Limited:

The principal issue to be decided in this appeal is whether these interest amounts were properly disallowed by the Minister on the ground that they did not fall within the meaning of paragraph 11 (1)(c) of the Income Tax Act as it read at that time. The notice of appeal and the reply of the Minister contain in full the factual details of the various transactions which finally resulted in this litigation. Instead of repeating those facts in full as they were presented and further commented on by counsel for the respective parties, it may suffice if I summarize these in substance because there appeared to be little or no dispute about what actually happened—the real issue being what interpretation should be given to those facts and the sequence in which they occurred in connection with the relevant statutory provisions.

The pertinent facts in this appeal are as follows:

1. The appellant company, a wholly-owned subsidiary of Distillers Corporation-Seagrams Limited owed to British Columbia Distillery Ltd an amount of $13,460,606 and to Thomas Adams Distillers Ltd an amount of $4,286,950 as at December 22, 1966, making the appellant’s indebtedness to these affiliates a total of $17,747,556. British Columbia Distillery Ltd produces its own goods, ages them in warehouses over a period of some five years before putting them on the market. Thomas Adams Distillers Ltd is strictly a selling company of some fifty employees with its own trade-marks and sales offices located in Montreal, Quebec City, New Brunswick, Newfoundland and British Columbia. However, Thomas Adams Distillers Ltd does not operate a distillery but purchases its stock from its sister distilleries. Both these companies are not only affiliated with the appellant company but the appellant company acted as a bank or clearing house for these affiliates. The receivables of British Columbia Distillery Ltd and Thomas Adams Distillers Ltd were transferred, collected and kept by the appellant company which in turn paid the affiliates’ indebtedness. These amounts so collected by the appellant company, which over a period of years created a substantial debit balance vis-à-vis its affiliates, was used by the appellant company as working capital. It was explained that the Distillers Corporation Limited, the appellant company, owns in Canada alone six distilleries and seven plants, and owing to the nature of its product, and the ageing process applied, it constantly needs an astronomical working capital. The general financing policy of all the Seagram corporations is characterized by “self or intercorporate” financing whereby no interest is charged to affiliated corporations and very little borrowing is done on the money market.

2. Distillers Corporation-Seagrams Limited which was described as the grandparent company is purely a financial holding company owning some 46 companies in Canada and some 100 companies abroad.

On or about December 22, 1966 Thomas Adams Distillers Ltd loaned to British Columbia Distillery Ltd an amount of $4,286,950 and on December 22, 1966 British Columbia Distillery Ltd and Thomas Adams Distillers Ltd each paid to Distillers Corporation- Seagrams Limited (the grandparent company) dividends in the amount of $14,000,000 and $3,000,000 respectively, a total of $17,- 000,000.

3. On December 22, 1966 Distillers Corporation-Seagrams Limited in turn loaned to Centenary Distillers Ltd, another Seagrams affiliate, but a foreign business corporation, an amount of $17,000,000.

4. On the same day, December 22, 1966, Centenary Distillers Ltd then purchased $16,909,806 of stock in Gulfstream Insurance Limited, a wholly-owned subsidiary of Centenary Distillers Ltd in the Bahamas.

As the fire protection equipment and sprinkler systems of the Seagrams chain of distilleries and warehouses improved over the years, and because of the high cost of insurance protection, some thought was given by the Seagrams corporations to self insurance. In 1959 Gulfstream Insurance Limited began to assume the insurance risks of Seagrams corporations as well as those of other clients up to a maximum of $200,000 to $250,000 with re-insurance by third parties. In 1966 Gulfstream Insurance Limited had proven to be a profitable business venture and began assuming the risk of all Seagrams’ interests in Canada, the United States and the United Kingdom. However, it was felt that the limit of risks assumed by Gulfstream Insurance Limited should be raised from $200,000 to $2,000,000. According to the applicable “ten to one” risk-assuming rule, for Gulfstream Insurance Limited to be allowed to assume risks of up to $2,000,000, an amount of some $16,000,000 had to be added to its already paid-up capital and surplus of some $4,000,000. The stock subscription by Centenary Distillers Ltd achieved this result. Gulfstream Insurance Limited is presently assuming risks of up to $2,000,000 but has limited its activities to the Seagrams family of corporations exclusively.

5. On December 22, 1966 the appellant company acquired from Gulfstream Insurance Limited an amount of $17,500,000 at 6% interest. The interest payments on this amount were made by the appellant to the lender in the years 1967, 1968 and 1969 and are the subject matter in issue in this appeal.

6. Also, on December 22, 1966 the appellant company paid to British Columbia Distillery Ltd and to Thomas Adams Distillers Ltd the amounts of $13,460,606 and $4,286,950 respectively owed to them.

As an aid to my summary of the facts I have reproduced the following diagram showing the intercorporate relationships between the companies which have played a part in the transactions which gave rise to this appeal.

F. This corporation, also wholly owned by Distillers Corporation-Seagrams Limited, finally lends $17,500,000 to Distillers Corporation Limited, the taxpayer appellant in this case, thus restoring the working capital of this appellant of which it was deprived in transaction A.

The result: (1) obtains a deductible interest expense of 6% of $17,500,000.

(5) receives the same interest amount as tax-free (Bahama) income.

(1) paid withholding tax on the interest payment.

At the hearing the following agreement dated June 18, 1974 signed by both counsel was filed with the Board:

TAX REVIEW BOARD

IN RE: THE INCOME TAX ACT

and

DISTILLERS CORPORATION LIMITED

Appellant

and

THE MINISTER OF NATIONAL REVENUE

Respondent

The parties hereto, through their undersigned attorneys, hereby agree solely for the purpose of the present case that:—

1. Prior to December 22, 1966, the sum of $13,460,606 owing by the appellant to British Columbia Distillery Ltd and the sum of $4,286,950 owing by the appellant to Thomas Adams Distillers Ltd were used by the appellant to earn taxable income.

2. The interest charged by Gulfstream Insurance Limited on its loan to the appellant of $17,500,000 was at a reasonable rate.

Montreal, June 18, 1974

Phillip F Vineberg (signed) Attorney for Appellant

Jean Potvin (signed)

Attorney for Respondent

Counsel for the appellant emphasized that the deductibility of interest payments is a statutory allowance, and must be allowed if it complies with the conditions of paragraph 11 (1 )(c) of the Act. The appellant holds that the original moneys borrowed from British Columbia Distillery Ltd and Thomas Adams Distillers Ltd were used for the purpose of earning income from the business of the appellant within the meaning of paragraph 11 (1)(c) and that no part of the borrowed money was used to acquire property the income from which would be exempt from tax. The appellant further stated that subsection 11 (3b) of the Act establishes an irrefutable presumption that money borrowed to repay money previously borrowed shall be deemed for purposes of paragraph 11 (1)(c) to have been used for the purpose for which the money previously borrowed was used. The appellant contended that the contents of the above agreement signed by the respondent in fact settled the case in that it establishes that the conditions set out in paragraph 11(1)(c) and subsection 11 (3b) have been met and concludes that all the interest payments made by the appellant should be allowed.

The appellant also contended that subsection 137(1) does not apply to interest payments and points out (1) that interest is not merely an outlay or expense but a statutory allowance provided for under para- graph 11(1)(c); (2) the department cannot on the one hand admit that the interest paid was reasonable and on the other hand claim that it artificially reduces income; (3) that interest payments cannot logically be considered an artificial expense; (4) that the use made by the appellant of the $590,194, the interest payment on which was allowed, was exactly the same as that made of $16,909,806 on which the interest payments were disallowed.

In argument, counsel for the respondent raised three main points. First, the respondent held that the transactions that took place on December 22, 1966 between the appellant and the affiliated companies were a sham because it was merely a programmed and timed circuitous exchange of cheques for some $17,000,000 between affiliated companies—none of which would otherwise have had a sufficiently large bank balance to issue such a cheque. The respondent concludes, therefore, that no money was in fact borrowed during the course of these transactions.

Secondly, the respondent questions whether paragraph 11 (1)(c) of the Act is applicable, holding that even if the appellant had in fact borrowed the $17,500,000 to repay British Columbia Distillery Ltd and Thomas Adams Distillers Ltd, this was not done for the purpose of earning income. The respondent contends that the moneys owed to British Columbia Distillery Ltd and to Thomas Adams Distillers Ltd were accounts payable resulting from a method chosen by the appellant in operating related businesses and that the reimbursement of such debts by the appellant does not necessarily imply that its purpose was to produce income for itself. The respondent then refers to the relationship existing between the appellant, Distillers Corporation Limited, who has allegedly borrowed the money, British Columbia Distillery Ltd and Thomas Adams Distillers Ltd, and points out that there is no evidence that the appellant derived any benefit whatsoever from the operations of British Columbia Distillery Ltd or from that of Thomas Adams Distillers Ltd and that no income was gained by the appellant as a result of its alleged borrowing from Gulfstream Insurance Limited for reimbursement of the amounts issued to these two companies, and he concluded that paragraph 11 (1)(c) of the Act cannot apply.

The respondent further holds that subsection 11 (3b) of the Act is not applicable because although there may exist a debtor-creditor relationship between the appellant and British Columbia Distillery Limited and Thomas Distillers Ltd, the indebtedness was not the result of borrowings within the meaning of the section but the result of a special financial arrangement with the affiliated corporations.

The respondent’s third main point is that allowing the deduction of the interest payments on $17,500,000 made by the appellant company would unduly or artificially reduce its income.

There is really no dispute between the parties as to the facts of this appeal. However, notwithstanding other considerations that have been introduced, the point of law at issue is simply whether all of the interest payments made by the appellant in 1967, 1968 and 1969 in respect of an amount of $17,500,000 allegedly borrowed are deductible pursuant to paragraph 11(1)(c) of the Act, or whether we are faced here with artificial transactions or shams as claimed by counsel for the respondent.

The appellant operating several distilleries would evidently require a very substantial working capital. Whether this capital is acquired on the money market or acquired from an affiliated company with or without interest is a business decision which the appellant was perfectly free to make. We know, of course, that the $13,460,606 and $4,286,950 owed by the appellant to British Columbia Distillery Ltd and Thomas Adams Distillers Ltd, though not actually borrowed by the appellant, nevertheless was a bona fide debt resulting from the appellant’s collection, reception and retention of the British Columbia Distillery Ltd’s and Thomas Adams Distillers Ltd’s accounts for merchandise made over a period of years with the consent of the affiliated companies.

Such inter-company clearing house or banking is legal and according to the testimony of Mr R G Lammers, vice-president of the Bank of Montreal, accepted by the banks.

I am satisfied that Thomas Adams Distillers Ltd is not merely a shell company as claimed by the appellant, but even if it were, it would in no way affect the point in issue in this appeal. There is nothing intrinsically wrong in Thomas Adams. Distillers Ltd lending $1,286.950 to British Columbia Distillery Ltd in order to enable it to pay dividends to Distillers Corporation-Seagrams Limited even without interest. Nor is there anything wrong in the payment of $14,000,000 and $3,000,000 in dividends to Distillers Corporation-Seagrams Limited by British Columbia Distillery Ltd and Thomas Adams Distillers Ltd respectively. Distillers Corporation-Seagrams Limited has every right to lend Centenary Distillers Ltd $17,000,000 and the latter every right to subscribe $16,909,806 in Gulfstream Insurance Limited stock. The reason given for the increase of Gulfstream’s capital in order to permit it to assume greater insurance risks is credible. It is not abnormal for an insurance company, even an off-shore captive insurance company, to lend large amounts of money to corporations such as the loan of $17,500,000 by Gulfstream Insurance Limited to Distillers Corporation Limited. The interest rate of 6% on a loan, of course, is very reasonable by any standards. Nor is there anything unusual about a company arranging its finances to pay its debts as the appellant did in the last of a series of transactions within the Seagrams Corporation.

I am satisfied, as indeed is counsel for the respondent according to the signed agreement to that effect, that the amounts of $13,460,606 and $4,286,950 owed by the appellant to British Columbia Distillery and to Thomas Adams Distillers Ltd were used by the appellant as working capital to earn income from its business. I am also satisfied that the appellant acquired $17,500,000 from Gulfstream Insurance Limited to pay British Columbia Distillery Ltd and Thomas Adams Distillers Ltd the debts owed to them.

There is therefore nothing legally unsound or contrary to accepted accounting principles and practices in any or all of the transactions that took place between the Seagrams affiliates on December 22, 1966, and each transaction taken separately or all of them taken collectively are legally binding on the parties.

However, I must admit that ! am somewhat concerned with the overall result of the series of transactions taken as a whole whereby $17,500,000 of Canadian money could at one stroke of a pen be circulated among affiliated corporations in a full circle and end up at the point of origin as an interest-bearing loan payable to a tax free, off-shore, wholly- owned subsidiary of the Seagrams family of corporations.

In these transactions although the appellant company, which heretofore financed its operations with moneys which had been made available without cost now has to borrow the same amount at a cost of 6% per annum, it is quite evident that a very important result of the transaction as a whole is a considerable tax saving to the Seagrams concern. It is true that Gulfstream Insurance Limited paid withholding taxes through the appellant company but it was more than offset by the fact that Gulfstream Insurance Limited did not have to pay income tax at its place of residence and that the appellant could also deduct the considerable interest payments on the loan as a legitimate expense for tax purposes.

Nevertheless, having closely considered the sequence of each transaction which finally resulted in the interest-bearing loan from Gulfstream Insurance Limited to the appellant, I have come to the conclusion that under the circumstances of this appeal the Board must consider the validity of the transactions and cannot ignore nor dismiss the existence of the corporate entity of each of the affiliated companies. The Board, in my view, does not have any alternative but to accept the legal effects of each and all of the transactions.

Whether or not these transactions taken as a whole might qualify as an improper tax avoidance scheme pursuant to section 138 of the Act as it read at the relevant time is a very moot question. In any event, the Board has no jurisdiction in such tax avoidance schemes and if any correction is required in such instances it must be made by a body other than the Tax Review Board.

In my view the decision to be rendered by the Board in this appeal must be based on the other relevant sections of the Income Tax Act, viz paragraph 11 (1)(c), subsections 11 (3b) and 137(1) of the old Act.

Whether the facts of this appeal taken as a whole might or might not fall within the purview of section 138 of the Income Tax Act, they do not in my opinion fall within the dispositions of subsection 137(1) of that Act.

The deduction of interest payments on borrowed money used for the purpose of earning income from a business is statutory. The Minister has not denied that the appellant company did indeed owe $13,460,606 to British Columbia Distillery Ltd and $4,286,950 to Thomas Adams Distillers Ltd. The respondent, through his solicitor, specifically stated in the signed agreement that these amounts were used by the appellant to earn income and that the interest charged by Gulfstream Insurance Limited on the loan made to the appellant was reasonable. Nor has the Minister denied that the appellant in fact paid to British Columbia Distillery Ltd and Thomas Adams Distillers Ltd the moneys owed them with the money borrowed from Gulfstream Insurance Limited.

Under the circumstances I cannot see how the Board could come to the conclusion that the deduction of the interest payments on moneys borrowed to earn income would unduly or artificially reduce the appellant’s income within the meaning of subsection 137(1) of the old Act.

Counsel for the respondent holds that the said transactions are a sham intended to give to third parties the appearance of creating legal rights and obligations different from the actual rights and obligations which existed between the parties and concluded that there existed no legal obligation for the appellant to pay interest to Gulfstream Insurance Limited.

Each transaction took place between legal entities, albeit affiliated corporations, and were valid and legally binding on the parties. The borrowing of $17,500,000 and the payment by the appellant of its debts as well as the increase of the Gulfstream Insurance Limited capital are valid commercial objectives of the Seagrams corporations which were legally, commercially and effectively carried out by these transactions.

The Board cannot consider any one of these transactions as being without legal effect, or as artificial, unfounded, unbusinesslike and in a general sense unreasonable. The Board concludes that the transactions per se were not a sham and there did exist a legal obligation on the part of the appellant to pay interest on the money borrowed from Gulfstream and that such interest payments were deductible pursuant to paragraph 11(1)(c).

All relevant transactions were executed in a proper way and one of the results was that the intercorporate method of financing through interest free loans and advances was changed by a system of interestbearing loans*

It would appear to me that this change is by far not as drastic as changing equity financing of a company into financing with borrowed funds. That situation occurred in the case of Trans-Prairie Pipelines Limited v MNR, [1970] CTC 537; 70 DTC 6351. In that case the taxpayer company redeemed a substantial amount of equity capital on which it did not have to pay any interest and replaced ii by capital it borrowed at a cost of a certain amount of interest. On that occasion, as well as in the case before us, the Minister complained that the company did not have to do that and for that reason the interest should not be allowed.

Mr Justice Jackett, however, decided that it was entirely up to the management of that corporation to determine the method of financing considered appropriate and desirable for that corporation and for the purposes of this appeal I believe I can add that the judicious planning of one’s affairs so that less tax is attracted is not prohibited by the Income Tax Act.

In the case at bar, the management of the Seagram concern found it wise, attractive and good business to change its method of financing and it managed at the same time to obtain a substantial tax saving.

In summary, therefore, I hold (1) that the transactions were legally binding and that the appellant in fact and in law borrowed $17,500,000 from Gulfstream Insurance Limited, thereby contracting a legal obligation to pay to Gulfstream Insurance Limited interest at the rate of 6% per annum which it, in fact, paid; (2) that the money borrowed by the appellant was used by it to repay to the affiliated corporations moneys owing which had been used by the appellant as working capital to earn income for itself. On the basis of these two facts I conclude that the requirements of paragraph 11 (1)(c) and subsection 11 (3b) have been met.

I further hold that the transactions gave legal effect to valid commercial and business objectives and that they cannot be considered a sham.

Finally, I hold that the interest payments on moneys to which this appeal pertains were borrowed to earn income and cannot be considered as unduly or artificially reducing income within the meaning of subsection 137(1) of the Act as it read at the relevant time.

For these reasons the appeal is allowed.

Appeal allowed.