John Donald Irwin v. Minister of National Revenue, [1978] CTC 3247, [1978] DTC 1876

The Chairman:—The appeal of John Donald Irwin is from assessments by which the Minister of National Revenue disallowed ‘the deductions of life insurance premiums in the amount of $1,880.50 for the 1973 taxation year and in the amount of $1,460.50 for each of the 1974 and 1975 taxation years.

Facts

The facts are not disputed and can be summarized as follows. The appellant, a real estate broker for Irwin, Sargent & Lowes Limited, the son of Roy Irwin, a shareholder of the said firm, entered into an agreement dated May 1, 1972, to purchase his father’s 166% common shares in the firm for $109,697.

The agreement (Exhibit A-1) provided that the payment of $109,697 by the appellant would be made from the profits accruing from his shares in Irwin, Sargent & Lowes Limited and paid directly: by the firm to the appellant’s father. These profits exclude, of course, the appellant’s basic salary income and the insurance premiums paid on a life insurance policy to be taken on the appellant’s father. The payments agreed to were on principal only and were to be not less than $5,000 a year for the first five years, interest to be paid in subsequent years at an agreed rate. (Exhibit A-1). The shares were then, through an hypothecation, assigned to the father as collateral security for the appellant’s indebtedness. (Exhibit A-2).

The agreement required that the appellant purchase a $50,000 term life insurance policy on the life of his father and pay the premiums when due. In the event of the father’s death the $50,000 (or a part thereof) would be paid on the balance owing on the shares, by the appellant to the fathers estate. On January 29, 1973 a 10-year term insurance policy was purchased from National Life by the appellant on the life of his father in the amount of. $50,000. (Exhibit A-3).

By a further agreement between the appellant and his father, Roy Irwin, dated February 1, 1972, it was acknowledged that the appellant had purchased a $50,000 insurance policy on his father’s life, as a supplement to the agreement dated May 1, 1972. (Exhibit R-1).

As pointed out by counsel for the respondent there appeared to be some discrepancy as to relative dates of the two agreements. Evidence was led to the effect that the supplementary agreement (Exhibit R-1) was dated February 1, 1972, and that the acknowledgement of the purchase of the same life insurance was on the original copy dated February 2, 1973.

The Issue

The issue is whether or not the appellant could properly deduct from income the life insurance premiums on his father’s life in each of the pertinent taxation years as expenses incurred in the course of borrowing money used by the taxpayer for the purpose of earning income within the meaning of subparagraph 20(1 )(e)(ii) of the Income Tax Act, SC 1970-71-72, c 63, as amended.

The Appellant’s Contention

In his Notice of Appeal the appellant contended that when he purchased the shares of the Company from his father, he did purchase property that would produce non-exempt income, and that inasmuch as he did not pay the full purchase price in cash at the time of the sale, but gave a debt instrument back to his father, he became indebted to his father for the balance of the purchase price. He submits therefore that the transaction did give rise to a borrower/ lender relationship. He further submitted that since the life insurance requirement was extracted from him by his father as one of the terms of the sale, the expense of meeting that term is an expense within the meaning of subparagraph 29(1 )(e)(ii) [sic].

The Respondent’s Position

In his Reply to Notice of Appeal the respondent stated:

The respondent submits that at no time did the legal relationship of borrower and lender of money exist between the appellant and Roy K Irwin respectively pursuant to the Agreement of Purchase and Sale of 166 /3 shares of capital stock in Irwin, Sargent and Lowes Limited. The respondent Submits, therefore, that those term life insurance premiums paid by the appellant pursuant to the terms of the Agreement for Purchase and Sale of certain capital stock in Irwin, Sargent and Lowes Limited on the life of Roy K Irwin were properly disallowed by the respondent in that such premiums were not expenses incurred in the 1973, 1974 and 1975 taxation years in the course of borrowing money used by the appellant for the purpose of earning income from a business within the meaning of subparagraph 20(1 )(e)(ii) of the Income Tax Act.

Finding of Facts

The evidence given by the appellant and his father establishes to my satisfaction that the purchase by the appellant of a $50,000 life insurance policy was a sine qua non condition in the acquisition by the appellant of his father’s shares in the real estate firm of Irwin, Sargent and Lowes Limited. The favourable terms of the agreement clearly indicate the father’s desire to transfer his interest in the business to his son while at the same time insuring that he or his estate would eventually receive the full purchase price for his: shares.

The question to be determined is the nature of the legal relationship between the appellant and his father as a result of the terms of the sale of shares agreement. Does a borrower-lender relationship, in these circumstances, exist between the purchaser and vendor? Did the appellant in paying premiums of the said life insurance policy incur expenses in the course of borrowing money?

The Law

Dealing with allowable deductions in computing income from a business, the pertinent section of the Act, in substance, is subparagraph 20(1 )(e)(ii) which reads as follows:

20. (1) Nothwithstanding 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 may reasonably be regarded as applicable thereto:

(e) Expense of issuing shares or borrowing money.—an expense incurred in that year,

(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),

It is common ground that the appellant purchased property that would produce taxable income; the purchase price was specified; the debtor-creditor relationship existed; the hypothecation of the shares constituted a security for payment of the purchase price of the shares; the life insurance policy was a condition of the Agreement and the insurance premiums were in fact paid by the appellant in the pertinent taxation years.

Case Law

The case of T E McCool Limited v MNR, heard in the Exchequer Court [1948] CTC 247; 3 DTC 1202, and appealed to the Supreme Court of Canada [1949] CTC 395; 1949-1950 DTC 700, cited by counsel, was the source of considerable discussion.

Reference was made by both Courts to section 5(1 )(a) and (b) of the Income War Tax Act and consideration was given to the meaning of “borrowed capital”.

The Headnote in the decision of the Exchequer Court states:

Held, that the Minister acted on a wrong principle of law in fixing depletion on the cost to the predecessor in title, viz McCool; that the cost to the company was $150,000; that the Minister could not ignore the separate identity of the company and its shareholders, and that it was an improper exercise of his discretion for the Minister to determine the depletion allowance to the company by reference to the cost of the timber to McCool, the predecessor in title.

Held, further, that the interest on the note was not deductible, since it was not interest on ‘borrowed capital’ within paragraph 5(1 )(b) of the Act, but rather was interest on a portion of the purchase price owing by the purchaser to the vendor.

Semble: a purchaser who indirectly borrows from his vendor by giving a note or bond for part of the purchase price is not a borrower for purposes of paragraph 5(1 )(b) of the Income War Tax Act, whereas if he borrowed money from a third party and paid the vendor in full he would be.

The Supreme Court allowed the Crown’s appeal on the basic issue, viz, depletion of timber limits (paragraph 5(1)(a)) but held as had the Exchequer Court that the interest on the note was not interest on borrowed capital within the meaning of paragraph 5(1)(b) of the Income War Tax Act.

Counsel for the appellant contended that paragraph 5(1)(b) of the Income War Tax Act had been repealed and was not applicable to the present issue and that the references made by the Courts to interest on borrowed capital were obiter dicta.

Counsel for the respondent while admitting that paragraph 5(1)(b) of the Income War Tax Act had been repealed contended that the concept contained therein was reflected in subparagraph 20(1)(e)(ii) and that the Courts’ decisions on the deductibility of interest paid on borrowed capital were not obiter but binding in applying subparagraph 20(1 )(e)(ii) of the Income Tax Act.

Paragraph 5(1 )(b) of the Income War Tax Act at the time read in part:

5. (1) “Income” as hereinbefore defined shall for the purpose of this Act be subject to the following exemptions and deductions:—

, .< -

(b) such reasonable rate of interest on borrowed capital used in the business to earn the income as the Minister in his discretion may allow . . .

In my opinion, other than the Minister’s discretionary power, the purpose and intent of paragraph 5(1)(b) is identical to that of subparagraph 20(1 ) (e)(ii).

I have come to the conclusion that the issues in the McCool case (supra) dealt with both the Minister’s discretionary powers in determining the amount of depletion allowance permissible (5(1)(a)) as well as the deductibility of interest on borrowed capital (5(1)(b)).

The findings and the comments of both the Exchequer Court and the Supreme Court as to the deductibility of interest on borrowed capital were not, in my opinion, obiter dicta. Repealing section 5 of the Income War Tax Act including paragraph 5(1 )(b), thereby withdrawing the Minister’s discretionary powers in no way invalidates the principles enunciated by the Courts as to what constitutes borrowed capital and is, in my opinion, binding on this Board in applying subparagraph 20(1)(e)(ii).

In the Supreme Court’s decision in McCool (supra) Mr Justice Estey describes what is meant by the term “borrowed capital” or “borrowed money”. At pages 413 and 708 respectively, he states:

Terms such as “borrowed capital”, “borrowed money” in tax legislation have been interpreted to mean capital or money borrowed with a relationship of lender and borrower between the parties. Inland Revenue Commissioners v Port of London Authority, [1923] AC 507; Inland Revenue Commissioners v Rowntree & Co Ltd, [1948] 1 All ER 482; Dupuis Frères Ltd v Minister of Customs. and Excise, [1927] Ex CR 207; [1917-27] CTC 326; 1920-1940 DTC 104. It is necessary in determining whether that relationship exists to ascertain the true nature and character of the transaction. In this case the promissory note arises out of an exchange in which, as already detailed, the purchase price was paid by assuming outstanding obligations, a small payment of cash, allotment of capital stock and the execution and delivering of this promissory note. Under such circumstances it cannot be held that the relationship of lender and borrower in respect to this note exists between the respondent company and the payee of the note.

In the same decision, Kellock, J states at pages 407 and 712 respectively:

I agree with the learned trial judge that the company cannot bring itself within the language used in section 5(1)(b). To employ the language of Viscount Finlay in Commissioners of Inland Revenue v Port of London Authority, )1923) AC 507 at 514, in order to enable the statute to apply, ‘there must be a real loan and a real borrowing.’ Here there is nothing more than unpaid purchase money secured by a promissory note which, in my opinion, is insufficient. It is not sufficient to say that if the company had borrowed the amount of the note and paid McCool it would have been entitled to the deduction. However that may be, that was not done and the statute does not apply. This appeal should also be dismissed.

Counsel for the appellant also cited Stock Exchange Building Corporation Limited v MNR, [1954] CTC 62; 54 DTC 1033, a decision which was appealed to the Supreme Court, [1955] CTC 5; 55 DTC 1014. This case dealt with the deductibility of compound interest. In the Headnote of the DTC it says:

In order that an interest may be deductible it must be payable pursuant to a contract that establishes a genuine borrower-lender relationship, not a debtor-creditor relationship.

The Supreme Court confirmed the Exchequer Court’s decision.

Counsel referred particularly to Mr Justice Estey’s statement to be found at pages 9 and 1016 respectively of the Supreme Court decision:

There is, with respect to the principal sum of $550,000, the relationship of lender and borrower, but, as to the interest, it is difficult to find any other relationship than that of debtor and creditor, particularly as the language in the Indentures goes no further than to say ‘and interest on overdue interest at the said rate’. In the circumstances, there is not here present that relationship of lender and borrower contemplated in Section 5(1 )(b). MNR v T E McCool Limited, [1950] SCR; [1949] CTC 395; 49 DTC 700.

Counsel for the appellant also cited Mr Justice Locke, in the Stock Exchange Building Corporation Limited Supreme Court decision, at pages 18 and 1020 respectively:

The section appears to me to contemplate the allowance of the interest on capital borrowed for the purpose of enabling the enterprise of the taxpayer to be carried on and, in respect of such moneys, to justify the allowance the relation of borrower and lender must be created at the outset between the taxpayer and the person to whom the interest is payable. In the present matter, there was no such borrowing of the interest in default: it was merely a debt which became payable by reason of the inability of the borrower to pay the interest as it fell due. It was not, in any sense, capital used in the business to earn the income, within the meaning of the subsection.

It is difficult to see how these statements by Justices of the Supreme Court can be of assistance to the appellant in supporting his contention that the interest on the premiums is deductible, unless he clearly establishes the existence of a lender-borrower relationship between himself and his father. The admitted existence of a debtorcreditor relationship between the two resulting from the purchase and sale agreement is not sufficient to consider the appellant as coming within the requirements of subparagraph 20(1)(e)(ii) of the Income Tax Act or for that matter the repealed paragraph 5(1)(b) of the Income War Tax Act.

Counsel for the appellant also cited Equitable Acceptance Corporation Limited v MNR, [1964] CTC 74; 64 DTC 5049. The issue in that decision of the Exchequer Court was very similar to that of the instant appeal and was whether the amounts of premiums paid by the appellant corporation on the life of its president constituted an expense in the year in the course of borrowing money used by the appellant for the purpose of earning income from its business, within the meaning of Subparagraph 11 (1 )(cb)(ii) of the Income Tax Act.

The facts however in the Equitable Acceptance case are distinguishable from those in the instant appeal in that the appellant actually borrowed and received monies which were used in the operation of its business. The purchase of the insurance policies which was also a condition of the loan was only collateral security for the loan and it was held that the premiums paid thereon had nothing to do with expenses incurred in the borrowing of money used by the taxpayer for the purpose of earning income.

In dismissing the appeal of Equitable Acceptance (supra) Cattanach, J of the Exchequer Court stated as follows at pages 79 and 5048 respectively:

In my view the cost of ihe purchase of the two life insurance policies and the maintenance in force thereof by the payment of premiums is not an expense incurred in the year in the course of borrowing money used by the taxpayer for the purpose of earning income from a business. While it is true that the purchase of these life insurance policies and their assignment to Triarch was a condition imposed by Triarch before making the loan to the appellant, nevertheless the true nature of the transaction was that the appellant acquired an asset which could be used, and was in fact used, as a collateral security necessary to borrow money to be used in its business. In short, the appellant, by the purchase of the two insurance policies, merely enhanced its position as a reliable lending risk.

In the instant appeal, although the purchase of a $50,000 life insurance policy was a condition of the purchase of share agreement, the subject transaction was basically the purchase and sale of a capital asset giving rise to a debtor-creditor relationship in which part of the appellant’s debt was secured by a life insurance on his father’s life and payable on his death to his father’s estate, if the balance of the selling price had not been paid. No evidence was produced, not even a promissory note as in the McCool case (supra), which might be interpreted as the appellant having borrowed money from his father and even less that the borrowed monies had been used by the appellant for the purpose of earning income from the business.

If the facts in the Equitable Acceptance case (supra) led the Court to conclude that the life insurance premiums paid by the appellant did not constitute an expense in the course of borrowing money then a fortiori do the facts in the instant appeal justify the same conclusion. Finding in Law

Paragraph 5(1)(b) of the Income War Tax Act, subparagraph 11(1) (cb)(ii) of the Income Tax Act, RSC 1952, c 148, and subparagraph 20(1)(e)(ii) of the Income Tax Act, SC 1970-71-72, c 63, as amended, deal with the same subject, viz the deductibility of interest paid on borrowed capital. Whether paragraph 5(1)(b) of the Income War Tax Act has been repealed or that the wording of subparagraph 11 (1)(cb)

(ii) of the Act has been changed in subparagraph 20(1)(e)(ii) of the new Act the concept and principles enunciated by the Courts as to what constitutes "borrowed capital” or "borrowed money” is, in my opinion, still valid and binding on this Board.

All the case law dealing with interest paid on borrowed capital for income tax purposes, cited in relation to this appeal, has been consistent in requiring that before interest paid on borrowed capital be exempt there must first exist a demonstrable borrower-lender relationship. The appellant has failed to establish that relationship between himself and his father and has not succeeded in bringing himself within the meaning and intent of subparagraph 20(1)(e)(ii) of the Act. Decision

The appeal, therefore, is dismissed.

Appeal dismissed.