Sherway Centre Ltd. v. R., [1998] 2 C.T.C. 343, (sub nom. R. v. Sherway Centre Ltd.) 98 D.T.C. 6121

McDonald J.A.:

1 This is an appeal by the Crown from a judgment of the Tax Court of Canada permitting the Respondent to deduct payments described as “participatory interest” in an issue of bonds pursuant to paragraph 20(1)(e) of the Income Tax Act[FN1: <p>R.S.C. 1985 (5th Supp.).</p>] .

Facts

2 In order to finance the construction of a large shopping centre in Toronto, Sherway Gardens, the Respondent obtained interim bank loans which, because of their interim nature, it had to replace with long-term financing. In order to obtain long-term financing, the Respondent issued $21.5 million in bonds which were not redeemable until 1991. At the time of the issuance of the bonds, the prevailing market interest rate was 10.25%. The two principal investors, Sunlife Insurance Company of Canada and Canada Life Assurance Company, were of the belief that a $20,000,000 issue at 10.25% per annum would impose such a severe debt service obligation on the Respondent that it might possibly lead to bankruptcy. The parties, therefore, agreed to issue the bonds at the below-market coupon rate of 9.75% per annum plus participatory interest each year equal to 15% of the Operating Surplus in excess of $2,900,000.

3 The 15% rate of participating interest was chosen because it was expected that this rate would increase the yield on the loan to approximately 10.25% (the prevailing market rate) provided the project reaped the benefits of inflation over the term of the loan.

4 The Respondent prepared an offering circular describing the participating interest feature to investors. The circular stated:

In addition to interest at the fixed rate of 93/4% per annum payable half-yearly (October 1 and April 1) the Series A Bonds will be entitled to participating interest each year equal to 15% of Operating Surplus (as hereinafter defined) in excess of $2,900,000 all as set out under the heading ‘Interest Rate’ on page 12 of this Circular.... The Series A Bonds will not be redeemable prior to October 1, 1991.

‘Operating Surplus’ for a specified period means the gross earnings and income of the Company from all Sources less able administrative, selling, renting and operating charges and expenses of every character and all fixed charges of the Company other than taxes on income interest on indebtedness, rent payable under the Ground Lease, depreciation, amortization and capital cost allowances for such periods.

5 The Respondent sought to deduct the participating interest payments in its 1987 and 1988 taxation years. The Minister disallowed the deduction on the grounds that the participating interest neither qualified as interest within the meaning of paragraph 20(1)(c) of the Act nor as an expense occurred in the year in the course of borrowing money used by the taxpayer for the purpose of earning income from a business pursuant to paragraph 20(1)(e) of the Act.

6 The Respondent appealed the Minister's assessment to the Tax Court which allowed the participating interest payment deductions under paragraph 20(1)(e) of the Act on the ground that the decision of this Court in Minister of National Revenue v. Yonge-Eglinton Building Ltd.[FN2: <p>[1974] C.T.C. 209 (Fed. C.A.).</p>] governed.

7 An important fact found by the Tax Court Judge which has already been mentioned but needs repeating for the purpose of this appeal is that all of the witnesses testified to the fact that at the time of making the deal interest rates were at historically high levels and that the participating interest was designed to increase the overall yield to the bond holders from 9.75% to a projected level of approximately 10.25%.

Relevant Legislation

Before proceeding into a discussion of my analysis it is necessary to set out the relevant sections of the Income Tax Act in full. Subsection 20(1) establishes the deduction permitted by the Act in the computation of one's income from business or property. It provides:

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 are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto.

(c) interest - an amount paid in the year or payable in respect of the year (depending upon the method regularly followed by the taxpayer in computing his income), pursuant to a legal obligation to pay interest on

(i) borrowed money used for the purpose of earning income from a business or property (other than borrowed money used to acquire property the income from which would be exempt or to acquire a life insurance policy)

(ii) an amount payable for property acquired for the purpose of gaining or producing income therefrom or for the purpose of gaining or producing income from a business (other than property the income from which would be exempt or property that is an interest in a life insurance policy).

Paragraph (e) permits the deduction of expenses associated with the issuing or selling of units, interests or shares or the cost of borrowing money. It states:

an expense incurred in the year:

• (i) in the course of issuing or selling units of the taxpayer where the taxpayer is a unit trust, interests in a partnership or syndicate, as the case may be, or shares of the capital stock of the taxpayer; or

• (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 including a commission, fee or other amount paid or payable for or on account of services rendered by a person as a salesman, agent or dealing in securities in the course of issuing or selling the units, interests or shares or borrowing the money, but not including any amount paid or payable as or on account of the principal amount of the indebtedness or as or on account of interest.

Analysis

8 In my opinion, the deduction for participating interest should have been allowed under both paragraphs 20(1)(c) and 20(1)(e) of the Act. Had it not been for the fact that some of the older jurisprudence has interpreted the definition of interest in a limited manner, I believe the Tax Court Judge would have deducted the amount of the participating interest payments under paragraph (c) as well. Because the jurisprudence interpreting the meaning of the definition of interest has not developed alongside of, or has not taken into account new and innovative financing schemes for new business ventures, the Tax Court Judge was forced to try and fit the deductions at issue in this case under paragraph 20(1)(e) of the Act. In my opinion, the participatory interest deduction equally belongs under paragraph 20(1)(c) of the Act. I agree, however, with the Tax Court Judge that the payments can also be deducted under paragraph 20(1)(e) of the Act.

9 The classic definition of interest is found in the 1947 Supreme Court of Canada case Saskatchewan (Attorney General) v. Canada (Attorney General)[FN3: <p>[1947] S.C.R. 394 (S.C.C.), at 411; affirmed[1949] A.C. 110 (Canada P.C.).</p>] where Rand J. defined interest broadly to include “the return or consideration or compensation for the use or retention by one person of a sum of money, belonging to, in a colloquial sense, or owed to another” This fairly broad definition has since been limited or more narrowly defined. For instance, in Ontario (Attorney General) v. Barfried Enterprises Ltd.[FN4: <p>[1963] S.C.R. 570 (S.C.C.).</p>] Judson J., after considering the definition of interest provided by Rand J. in Saskatchewan (Attorney General) v. Canada (Attorney General) and Halsbury's Laws of England, found that one of the essential characteristics of interest is that it accrues daily. He held that in the third edition of Halsbury's the text states: “‘Interest accrues de die in diem only at intervals, and is, therefore, apportionable in point of time between persons entitled in succession to the principal.’ This day-to-day accrual seems to me to be an essential characteristic.”[FN5: <p><em>Ibid.</em>at 575.</p>] However, as Krishna points out in his text, The Fundamentals of Canadian Income Tax,[FN6: <p>Krishna,<em>The Fundamentals of Canadian Income Tax</em>(5th ed.) (Scarborough: Thomson Canada Ltd., 1995) at 337.</p>] Judson J. incorrectly interpreted the Halsbury's definition:

But Halsbury merely says that where an amount is considered to be ‘interest’, it is deemed to accrue from day to day. Unfortunately, the statement was read to mean that a payment cannot be interest unless it accrues from day to day even if payable only at intervals. This interpretation of Halsbury has caused a good deal of misunderstanding as to the meaning of interest.

10 Another limiting characteristic placed on Rand J.'s definition of interest in Saskatchewan (Attorney General) v. Canada (Attorney General) is found in Balaji Apartments Ltd. v. Manufacturers Life Insurance Co.[FN7: <p>(1979), 100 D.L.R. (3d) 695 (Ont. H.C.).</p>] where the Ontario High Court of Justice held that in order to be interest, the payment must be a percentage of the principle sum. Based on these limiting characteristics to the broad definition of interest contemplated by Rand J. in Saskatchewan (Attorney General) v. Canada (Attorney General), the Tax Court Judge held that the payments were not interest because they did not accrue day-to-day and because they were not based on the principal outstanding at anytime but on the Operating Surplus of the shopping centre. I will deal with each of these findings in turn.

11 On the issue of whether the payments accrue day-to-day, in my opinion, the appropriate interpretation to be given to daily accrual of interest is that each holder's entitlement to interest must be able to be ascertained on a daily basis. I therefore agree with the Respondent that the interpretation of the quotation from Halsbury should not be read as establishing a legal principle that ‘compensation for the use of money is not interest unless it is expressed on a daily basis.’ Indeed, I agree with the Respondent when he states that “an amount paid as compensation for the use of money for a stipulated period can be said to accrue day-to-day.”

12 While the participating interest in this case was only payable once a year, nonetheless, it was based on a percentage of the Operating Surplus for the year. It was, therefore, capable of being allocated on a day-to-day basis and therefore meets the test for day-to-day accrual.

13 The more difficult issue is the requirement set out in Balaji Apartments that the interest must be a percentage of the principal sum. Balaji Apartments dealt with a mortgage which in addition to the mortgage payments also required the payment of a percentage of gross annual rentals after a bare figure was reached. The Court held that the payments related to the gross income were not interest because they were “not a percentage of, or in any way related to, the principal sum.”[FN8: <p><em>Supra</em>, at 697.</p>]

14 In my opinion, the Balaji Apartments case should not be read as limiting the deductibility of payments that while not directly related to the principal amount, nonetheless, are clearly related to that amount. Indeed, this case should be limited to facts similar to those on which it was decided--where it is clear that payment in question was in addition to the obligation to pay interest on the loan. This analysis appears self-evident when one reads the clause contained in the repayment provisions dealing with payment of the percentage of gross annual rentals in the Balaji Apartments case. The clause stipulates:[FN9: <p><em>Ibid.</em>at 696 (emphasis added).</p>]

It is further covenanted and agreed, in and for the consideration aforesaid, as a condition hereof, that until the said principal sum with interest thereon is fully paid as aforesaid, if the total gross annual income accruing to the mortgagor in any calendar year during the continuance of this mortgage from the said lands and buildings thereon or other facilities now on or which may hereafter be erected or be situated on the said lands, shall exceed the sum of $135,000,00 during any such calendar year ... then the said mortgagor will pay to the mortgagees, within 121 days after the end of each calendar year, a sum equal to 10% of the amount by which the said total gross annual income shall exceed the said sum of $135,000.00, any such percentage payment to be in addition to the payments of interest and principal hereinafter contained...

Indeed, after reading this comment Anderson J. held:[FN10: <p><em>Ibid.</em>at 697 (emphasis added).</p>]

On reading the words of the mortgage and the Act it seems to me that this contention should fail. The language of the mortgage is clear that the obligation to make a payment calculated as a percentage of gross annual income is to arise for any year when the income exceeds $135,000.00 is to be discharged by payment in one lump sum in the year next following, and that any such payment is in addition to the payments of interest and principal. The payment is not a percentage of, or in any way related to, the principal sum.

15 These passages indicate that the purpose of the percentage payments of the gross annual income in this case was that they were to be paid in addition to the interest payments provided the interest payments remained outstanding. In the case at bar, the evidence reveals that the purpose of the participating interest was to compensate for having to issue the bonds at a lower interest rate (9.75% as opposed to 10.25%) because had the Respondent issued the bonds at the 10.25% rate, there was a very real possibility of the Respondent going bankrupt. The Participatory interest, therefore, was another means of ensuring that the end result was that those buying the bonds would receive payments corresponding to the 10.25% interest rate (the rate it would have used had it been able to do so in the absence of the risk of bankruptcy). Thus, the payments were not in addition to interest as in the Balaji case but, instead, were in pursuit of the objective of a 10.25% interest rate. Moreover, it is important to point out that Anderson J. in Balaji contemplated that provided a payment was related to the principal sum it might be deductible as interest when he stated, “[t]he payment is not a percentage of, or in any way related to, the principal sum”.[FN11: <p><em>Ibid</em>.</p>]

16 The question, therefore, is whether the participating interest paid to the bond holders in this case can be said to be a percentage of, or in any way related to, the principal sum. In my opinion it can because, as the Respondent points out, the participating interest was payable only so long as there was principal outstanding. The portion of the participatory interest received was directly proportional to the amount of principal owed and, because the only purpose the participating interest served was to provide a rate of return on the principal outstanding from time to time, over the term of the loan to approximate a normal rate of interest for the loan. To hold otherwise, that is, to construe this provision as narrowly as previous case-law has done and not allow the deduction would, in my opinion, be to ignore the new commercial realities that were not considered by the courts when their past decisions were rendered.

17 Indeed, to find that the payments for participating interest are not deductible would be sending a message that the Income Tax Act discourages entrepreneurship. This is because those individuals looking to start-up new businesses but who need to find new and innovative ways of financing their ventures in order to succeed will not be entitled to deductions under the Act. We must also remember that the payments were currently taxed upon receipt by the bond-holders. There is, therefore, no tax avoidance gained from structuring the business in this manner. Indeed, the Respondent is merely attempting to receive the same deduction other businesses receive when making interest payments. Nor is this an attempt to hide another payment in the form of an interest payment.

18 If I am wrong in my characterization of the participatory interest payments as falling under paragraph 20(1)(c) of the Act, then I would allow the payments to be deducted under paragraph 20(1)(e) of the Act. While I am of the opinion that the Appellant is correct in stating that it is possible to distinguish the Yonge-Eglinton case from the case at bar, nonetheless, I am of the view that we should not do that. The participatory interest payments can be characterized as a cost of borrowing money or as being made for the use of borrowed money because they are “in connection with,” “incidental to,” or “arising from” the borrowing. It therefore fits within the test for deductibility under paragraph 20(1)(e). While Thurlow J. does state in his decision in Yonge-Eglinton that the payments “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,” nonetheless, I do not read this section of his judgment as limiting the participating interest payments at issue here. Indeed, at page 213 of his judgment he states:

The general idea of what is comprehended in subparagraphs (i) and (ii) of the paragraph 11(1)(cb) is I think indicated by the scope of what is expressly excluded by subparagraphs (iii) and (iv) for the fact that it was considered expedient to expressly exclude commissions and bonuses and payments as or on account of principal or interest, to my mind, shows that what is referred to as ‘an expense incurred in the year in the course of issuing or selling shares or borrowing money for the purpose referred to is capable of embracing a broad class of expenditures for such purposes. The easiest cases to think of are professional fees for necessary documentation and fees for registering documents but the wording is not confined to these or like expenses and to my mind it involves no stretch of the language used to treat it as including amounts of the kind in question here.

And, at page 214 he claims:

What appears to me to be the test is whether the expense, in whatever taxation year it occurs, arose from the issuing or selling or borrowing. 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 paragraph 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.

19 Lacroix J. in his concurring opinion also found at page 216:

This is the cost or the price the taxpayer had to pay, or in the words of the statute (11(1)(cb) this is the expense he had to incur or the financial burden he had to assume, in order to obtain the needed money for the purpose of earning income from a business or property.

Now, in my view it is difficult not to say that this expense was incurred or that financial burden was assumed or accepted by the taxpayer, in the course of borrowing money for the purpose of earning income from a business or property, according, this time, to the terms of subparagraph 11(1)(cb)(ii).

20 The appeal should be dismissed with costs.