Sherway Centre Ltd. v. The Queen, 96 DTC 1640, [1996] 3 CTC 2687 (TCC), aff'd 98 DTC 6121 (FCA)

Bonner J.T.C.C.: — This is an appeal from assessments under the Income Tax Act (“Act”) for the 1987 and 1988 taxation years. At issue is the deductibility under either paragraph 20(1 )(c) or paragraph 20(1 )(e) of the Act of payments described in an issue of bonds as “Participating Interest”.

In 1971 the appellant completed the building of a large shopping centre called Sherway Gardens. The shopping centre was intended for use and was in fact used and operated by the appellant for the purpose of earning income from its business. During construction financing was by way of bank loans. Those loans were of an interim nature and had to be replaced by borrowings arranged on a long-term basis. The appellant obtained that long-term financing by issuing $21.5 million in bonds. An offering circular prepared for purposes of marketing the bonds briefly describes the participating interest feature of them as follows:

In addition to interest at the fixed rate of 9 3/4 per cent 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 per cent 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 ...

The definition of “Operating Surplus” was:

“Operating Surplus” for a specified period means the gross earnings and income of the Company from all sources less all 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 period. [1]

The appellant was not to engage in any business other than the development and operation of the shopping centre and expansions thereof.

The Minister of National Revenue (“Minister”), in making the assessments in issue permitted the deduction of payments of conventional interest but disallowed the deduction of participating interest. The position taken by the Minister was that participating interest qualified neither as “interest” within the meaning of paragraph 20(1 )(c) of the Act nor as 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 ...” within the meaning of paragraph 20(1 )(e) of the Act. It was the Minister’s view that paragraph 20(1 )(e) does not authorize a deduction in respect of payments made as compensation for the use of borrowed money.

Three witnesses gave evidence at the hearing of the appeals. Michael Peter Prescott was in October of 1969 an officer of Sun Life Assurance Company of Canada (“Sun”). Sun intended to make a major investment in the issue of bonds proposed by the appellant and therefore was regarded as the “lead lender” upon which smaller investors tend to rely in relation to the adequacy of the security. Mr. Prescott prepared a memorandum for the investment committee of Sun analysing the features offered by the bonds and setting out his recommendations regarding the purchase of them. According to Mr. Prescott the ability of the borrower to service the debt, was a matter of considerable concern. At an interest rate of 9.75 per cent it was projected that the money available for debt service would exceed debt service costs by an adequate margin. However, given prevailing rates of interest, a return to the bond holders higher than 9.75 per cent was justified. Interest rates were at historically high levels and were continuing to rise. The arrangement for participating interest was made in order to offer bond holders a return over the life of the bonds in excess of 9.75 per cent by securing for the bond holders a portion of future growth in rents paid by the tenants of Sherway Gardens. Various projections were made of the potential total returns to the bond holders with results ranging from 10.06 per cent to 10.61 per cent. It was Mr. Prescott’s view that Sun, if lucky, would earn about 10.24 per cent overall. In order to ensure that the participating interest feature of the bond would have time to operate, Sun indicated to the appellant that it wanted the non-callable feature of the bonds extended from the 15 year period initially offered to 20 years. Agreement was reached on that point. It is clear from the testimony of Mr. Prescott that the participating interest feature of the bonds was negotiated between informed parties dealing with each other at arm’s length and was intended to increase the overall yield to the bond holders from 9.75 per cent to a projected level of 10.25 per cent, more or less.

William MacKenzie who, at the relevant time, was an official of Canada Life Assurance Company (“Canada Life”) also testified. Canada Life was the second largest investor in the appellant’s bonds. It purchased $3,000,000 worth. Mr. MacKenzie confirmed that debt service was a major concern to Canada Life. Prevailing market conditions suggested that an appropriate yield on the appellant’s bonds would be 10.25 per cent. Mr. MacKenzie indicated that a $20,000,000 issue at 10.25 per cent would impose a debt service obligation so onerous that default would loom as a possibility. In order to avoid the “nastiness” of default, Canada Life was prepared to accept a lower fixed rate coupled with a level of participation expected to make up the deficiency in later years. Mr. MacKenzie emphasized that Canada Life treated the participating bonds not as equity instruments but as fixed income securities that could be matched against fixed long-term annuity liabilities of Canada Life. Mr. MacKenzie noted that Canada Life owned much of the land upon which the appellant’s shopping centre was built. That land however was subject to a very longterm lease in favour of the appellant and the appellant’s reversionary interest was subordinated to the bonds.

Finally, evidence was given by Daniel F. Sullivan, deputy chairman of Scotia McLeod Inc., a major Canadian investment dealer. Mr. Sullivan testified as an expert in real estate finance. He expressed the opinion that participation payments in the latter years of a loan such as that in issue represent, in effect, delayed interest. They compensate for interest forgone in earlier years. He stated that lenders do a discounted cash-flow calcula- tion of both fixed interest and projected participation payments over the term of the loan in order to ascertain whether the combined income streams would approximate the yield required by lenders under prevailing market conditions. While there is no doubt whatever regarding the credibility of the evidence given by Mr. Prescott and Mr. MacKenzie, Mr. Sullivan’s evidence serves to confirm what was said by them regarding the process of arriving at the terms of the bonds and the role of participating interest from the viewpoint of the investor.

It is clear that, whether the participating interest payments are interest within the meaning of paragraph 20(1 )(c) or not, they are a cost incurred in borrowing money used to acquire and hold a capital asset and for that reason they constitute a “payment on account of capital” within paragraph 18(1 )(b) of the Act. Thus the payments are deductible, if at all, under either paragraph 20(l)(c) or 20(l)(e). The relevant portions of paragraph 20(l)(c) now follow:

20(1) Notwithstanding paragraphs 18(l)(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:

(c) 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), …

or a reasonable amount in respect thereof, whichever is the lesser;

Counsel for the appellant argued that the payments in issue are interest. His argument had two main bases:

a) Interest is compensation for the use or retention of money over a period of time; and

b) the legislature in the closing words of paragraph 212(l)(b) of the Act contemplates that interest may be computed “... by reference to revenue, profit, cash-flow, commodity price or any other similar criterion ...” and thus has indicated that the word interest as used in the Act is used in the broad sense and is not necessarily limited to amounts accrued on a day to day basis.

The decisions of the courts in Canada regarding the meaning of the word interest are difficult to reconcile. Some define the word broadly to include any form of compensation for the use of money owed to another person. For example in Satinder v. Minister of National Revenue, [2] this definition was adopted by the Federal Court of Appeal when dealing with the question whether a discount on a treasury bill was interest and therefore properly included in the income of the holder of the bill. The Court however was dealing with paragraph 12(1)(c) of the Act, a provision which uses such sweeping language that a precise delineation of the meaning of the word interest was not required.

Where the Courts have defined “interest” broadly they have in most cases relied on the following statement made by Rand J. in Reference validity of section 6 of Reference re validity of s.6 of Farm Security Act, 1944 (Saskatchewan)} [3]

Interest is, in general terms, 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.

In R. v. Melford Developments Inc.,* [4] the Supreme Court of Canada pointed out that this statement is not to be read literally. At page 509 (C.T.C. 333, D.T.C. 6283) Estey J. speaking for the Court stated:

Read literally, this statement would not require the payment of interest to be made to the owner of the capital advanced to the borrower. Indeed, it may be broad enough to embrace the very transaction now before the Court, namely a guaranty fee for the procurement of the money of another. If this indeed was the meaning in 1956 in the law of Canada of the term “interest”, then it can be argued that the 1974 Tax Act amendments are not in conflict with the 1956 statute. However, when the observation of Rand J., supra, is read in the context of the issue then before the Court it becomes apparent that no attempt was there being made to determine the extent of the definition of the term “interest” and I do not believe the comment should be taken as meaning that interest relates to anything other than the payment for the use of the principal advanced to the payor by the payee.

The Farm Security Act case is usually cited in support of broad definitions of the word interest. However in the reasons of Rand J. the following sentence serves to warn those who would adopt the broad definition too literally [5] :

There may be other essential characteristics but they are not material here.

One such essential characteristic was identified by the Supreme Court of Canada in Ontario (Attorney General) v. Barfried Enterprises Ltd.^. [6] In that case the issue was whether the Unconscionable Transactions Relief Act was intra vires the Legislature of Ontario. The legislation enabled the courts to grant relief “in respect of money lent” “where the cost of the loan is excessive” and “the transaction is harsh and unconscionable ...”. The term “cost of the loan” was defined to include, among other things, interest, discounts, bonuses, commissions and premiums. The Ontario Court of Appeal had held that the statute dealt with interest, a subject matter within Parliament’s exclusive jurisdiction. In reversing the decision of the Court of Appeal, Judson J., speaking for the majority of the Supreme Court, held that the legislation had as its object the modification of contracts and only incidentally affected interest. His Lordship held that ordinarily the unconscionable aspect of a money-lending contract was in the bonus, not in the interest rate charged and that bonuses were not interest. Referring to the previously cited passage from the reasons of Rand J. in the Farm Security Act case he stated:

This is substantially the definition running through the three editions of Halsbury. However, in the third edition (27 Hals., 3rd. ed., page 7) the text continues:

Interest accrues de die in diem even if payable only at intervals, and is, therefore, apportionable in point of time between persons entitled in succession to the principal.

The day-to-day accrual of interest seems to me to be an essential characteristic. [7]

Nothing in the evidence suggests that “Operating Surplus” as defined for purposes of computing the payments now in issue does or could accrue from day to day.

A third characteristic of interest is absent in this case. The participating interest payments are not computed as a percentage of, nor otherwise related to the principal sum outstanding from time to time on the bonds. In Balaji Apartments Ltd. v. Manufacturers Life Insurance Co.% [8] the High Court of Justice of Ontario considered whether a provision in a mortgage calling for payment of a percentage of the gross rent of the mortgaged premises in addition to principal and interest payable in blended instalments was unenforceable by virtue of section 7 of the Interest Act [9] . Anderson J. held that the payment was not interest. At page 697 (O.R. 277) he said:

The payment is not a percentage of, or in any way related to, the principal sum. I would not construe the stipulation for such payment or payments to be “.. interest ... chargeable by virtue of any other provision, calculation, or stipulation in the mortgage ...”

An arrangement remarkably similar to that in question was considered and the argument that the payment was interest was rejected in an English case, Walker & Co. v. Commissioners of Inland Revenue)® At page 653 Rowlatt J. said:

I have come quite clearly to the conclusion that the decision of the Commissioners in this case is right. They have allowed as a deduction the 200Z. a year which is the fixed interest in the money borrowed by the appellants for the purposes of their trade or business, but they have disallowed as a deduction the other sum of 300/. which seems to be nothing but a share of the profits of the business given to the lenders eo nomine. Of course both sums are paid as a consideration for the loan, that is why they are paid, but the two sums stand on entirely different footings. The persons who lent this money receive interest on the money lent which is payable to them as a debt, and for that purpose it is immaterial whether the business prospers or languishes, they also receive a share of what the business earns. That is not interest; it is simply a share of the profits. If there are profits they receive a share of them, if there are no profits they do not receive anything. The sum of 300/. is simply what it is called in the agreement — a share of the profits.

The amount of the payments now in issue is based not on the principal outstanding at any time but on the operating surplus of the shopping centre. Furthermore provision is made for the annual redemption of part of the bond issue. Despite the reduction of the principal by way of redemption of some of the bonds, the payments continue to be computed each year according to the same formula. They are simply divided among fewer bond holders. Thus, there is no linkage whatever between the amount of the debt outstanding at any time and the participating interest payable to the holders of the debt. It is my opinion that the payments in issue are not interest. They can more accurately be regarded as a cost of the borrowing itself than as a form of compensation for the use of the borrowed money.

Counsel for the appellant sought to draw an inference based on the use of the word “interest” in paragraph 212( l)(b) of the Act and the rule that:

Unless the contrary is clearly indicated by the context, a word should be given the same interpretation or meaning whenever it appears in an act.!! [11]

As previously indicated counsel asserted that interest must be taken to be used throughout the Act to mean any compensation for the use of money.

[192O] 3 K.B. 648.

That, he said, was the sense in which the word was used in paragraph 212( 1 )(b) and in particular in the closing words of the paragraph:

... and for purpose of this paragraph, where interest ... is computed by reference to revenue, profit, cash flow, commodity price or any other similar criterion ... the interest shall be deemed not to be interest described in subparagraph (ii) to

(vii) and (ix)

In my view the rule on which counsel relies is of limited assistance. In a 1959 decision of the Supreme Court of Canada, Fauteux J., speaking for the court, said:

... This rule of interpretation is only tantamount to a presumption, and furthermore, a presumption which is not of much weight. [12]

The presumption is, I should think, especially weak where, as here, no unifying theme or subject matter links paragraphs 20(l)(c) and 212(l)(b). The rules are not necessarily all tied together by one unifying theme. I am not prepared to assume that the word “interest” is used in Part XIII of the Act in the same way as in Part I. Before 1986 there was nothing in the Act which would warrant defining the word interest as used in paragraph 20(1 )(c) in an extended way to include payments computed by reference to profit. It is inconceivable that the addition in 1986 of language deeming such a payment not to be interest for some purposes under Part XIII should be construed as suddenly extending the scope of paragraph 20(1)(c).

I turn next to the question whether the participating interest payments are deductible under paragraph 20(1 )(e) of the Act. To qualify under that provision the payments must each constitute “... 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 ...”. In my view it is clear that the obligation to pay participating interest was incurred by the appellant in order to borrow the money. In the market which prevailed at the time the bonds could not have been sold had the only reward to the lender been the fixed or conventional interest.

Prior to the amendment effected by S.C. 1988 C. 55 subsection 12(2), paragraph 20(1 )(e) read: [13]

20(1) Notwithstanding paragraphs 18(l)(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) ... an expense incurred in the 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),

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 dealer 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;

This provision evolved from paragraph 1 l(l)(cb) of the former Act. The meaning of the predecessor was considered by the Federal Court of Appeal in Minister of National Revenue v. Yonge-Eglinton Building Ltd.'*. In that case the taxpayer secured a commitment for interim financing of its building by agreeing to pay to the lender (in addition to conventional interest at the rate of 9 per cent per annum on the amount owing from time to time) 1 per cent of the gross rental revenue from the building in each profitable year for 25 years. The obligation to make the 1 per cent payments continued in effect after the repayment of all monies which had been advanced by the lender. At issue was the deductibility under paragraph I l(l)(cb) of payments made under the 1 per cent provision in years subsequent to repayment of the loan. The relevant language of paragraph II ( 1 )(cb) was identical to that of paragraph 20(1)(e):

11(1) Notwithstanding paragraphs (a), (b) and (h) of subsection (1) of section 12, the following amounts may be deducted in computing the income of a taxpayer for a taxation year

(cb) an expense incurred in the year,

(ii) in the course of borrowing money used by the taxpayer for the purpose of earning income from a business or property.

The Court rejected the contention that deductible expenses of borrowing money are limited to expenses incurred when the borrowing takes place. Thurlow J. speaking for the majority of the Court stated, at page 213:

_,.. It does not seem to me to be a sensible or practical interpretation (and counsel for the Minister did not so contend) to hold that the deduction can only be made when the taxation year in which shares are issued or sold or money is borrowed is the same as that in which the expense is incurred because such a construction

[1974] C.T.C. 209, 74 D.T.C. 6180.

would arbitrarily exclude the deduction, for example, of professional fees incurred in connection with a share issue or a borrowing in a taxation year prior to the share issue or borrowing. It would also exclude the deduction, again for example, of expenses for formal documentation contemplated by the arrangements but incurred in a taxation year after that in which money has been borrowed on the strength of temporary or informal arrangements....

Later His Lordship addressed the question whether the costs in question, a form of commitment fee rather similar to the amounts in issue in this appeal, were “an expense incurred...in the course of borrowing money...”. He said, at page 214:

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 section 1 l(l)(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. In my opinion therefore since the amounts here in question arose from and were incidental to the borrowing of money required to finance the construction of the respondent’s building they fall within section I l(l)(cb)(ii).

In my view this decision governs. The appeals will therefore be allowed with costs and the assessments referred back to the Minister for reassessment on the basis that the appellant is entitled to deduct the amounts in issue.

Appeal allowed.