Emerson v. The Queen, 85 DTC 5236, [1985] 1 CTC 324 (FCTD), aff'd 86 DTC 6184, [1986] 1 CTC 422 (FCA)

Cullen, J:—There is no real dispute as to the facts in this case.

In 1981 the plaintiff was a general practitioner, medical doctor, carrying on practice in Woodstock, Ontario, and in 1981 filed an income tax return. On or about June 25, 1980 the plaintiff borrowed $100,000 from District Trust Company and used the proceeds to purchase shares in three small business corporations, Lonmed Holdings Limited, Medion Small Business Development Limited and Arcturus Small Busines Development Limited. As security for the loan, the plaintiff gave to District Trust a mortgage for $63,000 on his principal residence and a demand note for $37,000 both at the rate of interest of prime plus one-half per cent.

In August of 1981, the plaintiff disposed of all the shares, at a loss of $35,000, of which the plaintiff claimed, and was allowed one-half or $17,500, as a business investment loss in the 1981 taxation year. At the same time in August of 1981, the plaintiff borrowed $63,750 from the Royal Bank of Canada, secured by a mortgage on his principal residence at an interest rate of 18.25 per cent and used such borrowed money to repay the money previously borrowed from District Trust Company.

The Minister allowed the plaintiff to deduct the interest expenses on the loan from District Trust used to acquire the shares, from the time the shares were acquired and until they were disposed of by the plaintiff.

In computing income for the 1981 taxation year, the plaintiff claimed deductions on account of carrying charges of investment income which totalled $28,155.95. Included in this amount was $3,737.32 which the Minister of National Revenue (“Minister”) disallowed as a deduction, on reassessment of the plaintiff’s 1981 taxation year. This was the amount of interest paid to the Royal Bank during the period September 1, 1981 to December 31, 1981. The plaintiff claimed the $3,737.32 as an interest expense in 1981. By notice of reassessment mailed the 9th day of June, 1983, the plaintiff was reassessed by the Minister for Federal tax and Provincial tax and interest amounting to $1,746.14 of tax, and $439.26 of interest, for a total of $2,185.40 for his 1981 taxation year. The explanation given by the Minister in the accompanying T7W-C form was that “interest expense claimed in the amount of $3,737.32 is not deductible as any potential for earning investment income has ceased since the business was sold, per information submitted”.

By notice of objection dated August 8, 1983, the plaintiff objected to such 1981 reassessment. By confirmation, notification of which was given by the Minister on the 19th day of December, 1983, the Minister confirmed the plaintiffs 1981 reassessment.

Clearly, had the plaintiff retained the shares in Lonmed Holdings Limited, Medion Small Business Development Limited and Arcturus Small Business Development Limited, he would have been permitted to deduct the interest expenses on the loan from District Trust. However, having disposed of the said shares, and borrowing from the Royal Bank to repay the money previously borrowed from District Trust, the Minister determined that the interest expense was not incurred in respect of borrowed money and for the purpose of earning income from property in the plaintiffs 1981 taxation year. It is agreed that in the 1981 taxation year the plaintiff owned other property that earned income for him. The defendant suggests, however, that this is irrelevant.

The plaintiff suggests that there are three issues, namely: that business and property are treated differently under paragraph 20(l)(c) of the Income Tax Act; that subsection 20(3) of the Act deems that the moneys borrowed to repay are given the same tax treatment as the original moneys; and that so long as a taxpayer has “any source” of property income the taxpayer should be allowed a deduction under 20(1)(c).

I agree with the plaintiff that 20(3) deems that moneys borrowed to repay are given the same tax treatment as the original moneys. 20(3) reads:

(3) Idem. For greater certainty, it is hereby declared that where a taxpayer has used borrowed money

(a) to repay money previously borrowed, or

(b) to pay an amount payable for property described in subparagraph (l)(c)(ii) previously acquired,

the borrowed money shall, for the purposes of section 21 and paragraph (l)(c) or (k), be deemed to have been used for the purpose for which the money previously borrowed was used or was deemed by this subsection to have been used, or to acquire the property in respect of which the said amount was so payable, as the case may be.

However, does that help the plaintiff in the facts of this case? I do not believe so. Clearly, if the plaintiff had moved from District Trust to Royal Bank to secure the financing for the purchase of the shares in Lonmed Holdings Limited, Medlon Small Business Development Limited and Arcturus Small Business Development Limited and had retained these shares, in my view this section provides the vehicle necessary to maintain his right to a deduction. Here, however, the shares were disposed of.

I have some difficulty with the plaintiffs contention that business and property are treated differently under paragraph 20(l)(c). Subparagraph 20(l)(c)(i) reads: “borrowed money used for the purpose of earning income from a business or property” [Emphasis mine]. It strikes me that the two are not treated differently. Thus an interest expense is deductible under the Income Tax Act only as an expense of earning or producing income; and if the source of those earnings, be it business or property, no longer exists, the exemption disappears.

The defendant makes the point that in general, the financing of an operation or transaction for the purpose of producing income from that business or property in activities on capital account and the expenses in relation thereto are capital outlays and not expenditures directly related to the earning of income” and cites, Montreal Coke and Manufacturing Company v MNR, [1944] AC 126; [1944] CTC 94.

Specifically, interest expense or capital indebtedness, that is, borrowed money to commence a business or acquire the income-earning property, would not be deductible under paragraph 18( 1 )(a) or 18( l)(b) of the Income Tax Act except for an express statutory allowance. The Income Tax Act does provide an express statutory allowance in paragraph 20(l)(c) for interest expense in computing the income of the business or property source to which it is applicable.

An essential requirement, therefore, of any deduction on account of interest pursuant to 20(l)(c) is the existence of the source to which the expense relates and if the source has been terminated, as is the case here, the interest expense is no longer deductible. The continuing obligation to meet the interest costs of an outstanding loan, after the source has been extinguished, is not relevant.

The correct application of paragraph 20(l)(c) is further established by the express words of the opening statement, “in computing a taxpayer’s income for a taxation year from a business or property” in subsection 20(1) indicates that the allowances which are provided in the continuing words of the section are only such that would be deductions in a computation of income from a business or property, for a particular taxation year.

To sum up, as the defendant does,

In the case at bar, the interest expense in question, in the amount of $3,737.32, was charged on borrowed money used to replace a previous loan which had been used to finance the purchase of shares. However, at the time that the interest costs of $3,737.32 (interest being the cost of using someone else’s money over time) were incurred by the Plaintiff, the shares were no longer owned by the Plaintiff. The shares used to be the source of income against which the interest expense on the original loan was deductible in the computation of income from that source. Upon the disposition of the shares, there no longer was a source of income, nor a computation of income, in which that interest on the original loan, had it not been repaid, and the interest on the replacement loan, in fact used to repay the original loan, would be deductible outlays. The only purpose of the refinancing was to repay the money previously borrowed which was a debt owing by the Plaintiff and there is no ground for finding that the borrowed money to which the $3,737.32 interest related, was used for the purpose of earning income from a property.

For all the reasons above the appeal is dismissed.

Appeal dismissed.