Bowes & Cocks Ltd. v. MNR, 89 DTC 341, [1989] 2 CTC 2043 (TCC)

Bonner, T.C.J.:—The appellant appeals from assessments of income tax for the 1981 and 1983 taxation years and from a determination of a loss in respect of the appellant’s 1982 taxation year. In making the assessments and the determination the respondent disallowed the deduction of interest on borrowed money which the appellant used initially at least to acquire newly issued shares in a company which was already its wholly owned subsidiary. That company, Dabil Investments Limited (hereinafter "Dabil") was then wound up and its assets were distributed to the appellant. Its only asset of any significance was a parcel of one hundred acres of land located in Smith Township just north of Peterborough. Dabil bought the land in 1973 for the purpose of eventual development.

It was the appellant's position that it was entitled by virtue of paragraph 20(1)(c) of the Income Tax Act ("Act") to deduct the interest on the borrowed money. Paragraph 20(1)(c) provides:

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

an amount paid in the year or payable in respect of the year. . . pursuant to a legal obligation to pay interest on

(i) borrowed money used for the purpose of earning income from a business or property ....

The appellant asserted that the borrowed money was used for the purpose of earning income from the common shares of Dabil acquired with the proceeds of the loan or from the former property of Dabil which the appellant acquired upon Dabil’s winding-up. The property so acquired included the Smith Township land. Although that land was later sold at a loss, it was asserted that the appellant's sole shareholder, who was its directing mind and will, was of the view at all relevant times that the land could eventually be developed and sold at a profit.

The respondent's position was that what is relevant for purpose of paragraph 20(1)(c) is the direct use of the borrowed money. The purpose for which the borrowed money was used in this case was the acquisition of the Dabil shares. It was never contemplated that those shares would yield a dividend because, from the outset, the winding up and dissolution of Dabil was planned. According to the respondent it was not correct to view the transaction as one involving nothing more than an indirect acquisition of land. Rather, it was said, the appellant acquired shares of a company whose liabilities immediately before the issuance of those shares exceeded the fair market value of its assets and whose future prospects were bleak.

The first witness called was William Edward Cocks who, since 1972, has been president and sole shareholder of the appellant company. Mr. Cocks has, since 1950, been in the real estate business. He testified that the parcel of land owned by Dabil was bought by that company in December of 1973 at a cost of $90,000. It was located 1,000 feet north of the boundary of the city of Peterborough and the same distance to the west of the University. There were, he said, a number of residential developments in the area at the time of purchase. One had been developed in 1956, another in 1962 and yet another in 1968. The land use designation on the official plan was restricted rural. Mr. Cocks stated that he felt that development permission for a rural subdivision or an estate lot development could be obtained. He said that he spoke several times during the period from 1974 to 1981 to William Ben- ninger in furtherance of the proposal to subdivide the property. Mr. Ben- ninger was an Ontario Land Surveyor who possessed experience in the process of subdivision of land.

Mr. Benninger also gave evidence. He stated that in the early years in smaller communities it was common for a surveyor to deal with planning matters, that is to say, to advise on how land might be developed, to design subdivisions and to make presentations to local authorities. Mr. Benninger said that his firm was involved in about one third of the development projects in Peterborough. He stated that Mr. Cocks had asked him to look at the Smith Township property and to consider what could be done with it. He said that he could recall three or four times during the period from 1974 to 1981 when the possibility of development of the property was discussed by him and Mr. Cocks in a general way. However, nothing was ever resolved. Mr. Benninger expressed the opinion that the property did have potential for development although rezoning might have been required. He said there were many things that might have been done with it subject to obtaining the necessary approval. His opinion as to the potential of the property did not change in 1981. He asserted that the potential existed then and that in his opinion it still exists. He was of the view that annexation by the City of Peterborough would speed up development. When asked whether annexation appeared to be a possibility in 1974 his answer was that anything is possible and that it was reasonable to assume that at some time in the future land bordering on the city would be annexed.

The efforts to develop the property appear to have been of a casual and insubstantial nature. Mr. Benninger admitted that he never checked the zoning of the property and that he did not open a file with respect to its development. He said that nothing concrete was ever done.

Mr. Cocks loaned to Dabil the $20,000 down payment required to purchase the property. The balance of the purchase price was secured by a mortgage back to the vendor for a term of ten years repayable in annual instalments of $10,000 of principle and interest. Initially the shares of Dabil were held by Mr. Cocks and his sons. Dabil carried the property by means of bank loans secured by personal guarantees. Then the sons declined to put up any money and in March of 1981 Mr. Cocks took over their shares. In October of 1981 Mr. Cocks sold all six of the issued shares of Dabil to the appellant. On November 25, 1981 the appellant borrowed $700,000 from the bank and used $290,000 of the proceeds of that loan to subscribe for an additional 290,000 shares of Dabil. Immediately before that subscription was made Dabil's liabilities exceeded the total fair market value of its assets by some $181,000.

Dabil’s balance sheet as at November 26, 1981 showed a deficit of approximately $57,000 with assets being shown at current fair market value. A note to that balance sheet shows that the costs relating to the Smith Township land totalled some $252,000 including approximately $80,000 in bank interest and charges and about $37,000 in mortgage interest. Mr. Cocks conceded that the fair market value of the land at the time was not greater than $131,000.

By special resolution passed November 26, 1981 the winding up and dissolution of Dabil under the Business Corporations Act of Ontario was authorized. The Smith Township land was immediately conveyed to the appellant. Mr. Cocks stated that in winding up Dabil he was consolidating the two companies and putting all the property into one main company thereby saving audit fees. Also, he added, the bank was interested in cutting down the number of companies which he had. I may note at this point that neither reason seems particularly compelling.

The Smith Township property was sold by the appellant to William Clifford Cocks son of the witness William Edward Cocks in February of 1983. The witness explained that interest rates shot up in 1982, that the market for vacant land disappeared, and that the best offer that could be secured from an outsider for the Smith Township property was $70,000. After receiving appraisals at $90,000 and $86,000 the land was sold to his son for $100,000.

Counsel for the appellant argued that the inquiry in this case must focus on the use made by the appellant of the borrowed money. The relevant use was, he said, the use made from time to time. Initially the borrowed money was used for the purpose of acquiring shares and thus earning dividend income. The substituted use, in Mr. Smith's submission, was also for the purpose of earning income, namely income from the former business of Dabil, namely, the development of the land. He pointed out—correctly, in my view, that it was not necessary that the borrowed money should in fact have resulted in the earning of income by the appellant in the taxation years in which the interest expense was incurred. In this regard he referred to four decisions. [1]

Counsel for the Minister argued that it was necessary to look to the direct use made by the appellant of the borrowed money and that such use was the acquisition of shares not of land. When the appellant acquired those shares it had already been decided that Dabil would be wound up and dissolved and thus it could not be said that the shares were purchased in order to secure a source of dividend income. Mr. Pigeon argued further that even if it could be said that the shares continued to exist as a source of potential income up to the time of dissolution of Dabil in October of 1982, the source disappeared upon dissolution. Thus he submitted that interest costs subsequent to dissolution were not deductible. Mr. Pigeon speculated on various reasons which might have led Mr. Cocks and his advisors to structure the transaction as it was in fact structured. He pointed out for example that if Dabil had simply sold its land it would have been unable to realize sufficient proceeds to enable it to retire its bank loan with the consequence that Mr. Cocks would have been called on under his guarantee to the bank. The appellant was, he said, in a better position than Dabil to save Mr. Cocks harmless on the guarantee.

In The Queen v. Bronfman Trust [2] , the Supreme Court of Canada had occasion to analyse the operation of paragraph 20(1)(c) of the Act. At page 5064 (C.T.C. page 125) Dickson C.J.C., speaking for the Court, said:

The cases are consistent with the proposition that it is the current rather than the original use of borrowed funds by the taxpayer which is relevant in assessing deductibility of interest payments: see, for example, Lakeview Gardens Corporation v. M.N.R., [1973] C.T.C. 586; 73 D.T.C. 5437 (F.C.T.D.), per Walsh, J., for a correct application of this principle. A taxpayer cannot continue to deduct interest payments merely because the original use of borrowed money was to purchase income-bearing assets, after he or she has sold those assets and put the proceeds of sale to an ineligible use. To permit the taxpayer to do so would result in the borrowing of funds to finance the purchase of income-earning property which could be sold immediately without affecting the deductibility of interest payments for an indefinite period thereafter.

In the present case it cannot realistically be said that the borrowed money was used for the purpose of acquiring the Dabil shares. It is clear on the evidence that the acquisition of those shares was but the first step in a transaction intended from the outset to lead to the disappearance of Dabil and the acquisition by the appellant of Dabil’s assets the only significant one of which was the land. It was for that purpose that the appellant borrowed and used the money. The money was borrowed, the Dabil shares were acquired, the special resolution authorizing winding-up of Dabil was passed and the deed conveying the land was delivered to the appellant all within a matter of a few days. Deductibility of the interest must therefore in my opinion stand or fall on the use of the borrowed funds for the purpose of earning income by acquiring the Smith Township land for development and sale.

The evidence does not establish on the balance of probabilities that the appellant acquired that land for the purpose of earning income. In 1981 Mr. Cocks may still have entertained some hope of causing the appellant to develop or sell the land but it does not follow that the appellant's purpose in acquiring the lands in 1981 was the same as Dabil’s purpose in acquiring it seven years earlier. Reference was made in argument to section 88 of the Income Tax Act. However there is nothing in section 88 which requires that Dabil's 1973 purpose be attributed to the appellant following the winding- up. If in October of 1981 it was still thought possible to profitably dispose of the Dabil land some effort to carry out that intention would without doubt have been made and evidence as to that effort would have been led. Furthermore, it is difficult to imagine that the appellant's purpose was the earning of income from the development of the land when it acquired the land by means of a transaction involving a cost far in excess of the fair market value of the land at the time. In Bronfman Dickson, C.J.C., said the following at pages 124-5 (D.T.C. 5064):

Parliament created subparagraph 20(1)(c)(i), and made it operate notwithstanding paragraph 18(1)(b), in order to encourage the accumulation of capital which would produce taxable income. Not all borrowing expenses are deductible. Interest on borrowed money used to produce tax-exempt income is not deductible. Interest on borrowed money used to buy life insurance policies is not deductible. Interest on borrowings used for non-income earning purposes, such as personal consumption or the making of capital gains is similarly not deductible. The statutory deduction thus requires a characterization of the use of borrowed money as between the eligible use of earning non-exempt income from a business or property and a variety of possible ineligible uses. The onus is on the taxpayer to trace the borrowed funds to an identifiable use which triggers the deduction. Therefore, if the taxpayer commingles funds used for a variety of purposes only some of which are eligible he or she may be unable to claim the deduction: see, for example, Mills v. M.N.R., [1985] 2 C.T.C. 2334; 85 D.T.C. 632 (T.C.C.); No. 616 v. M.N.R., 22 Tax A.B.C. 31; 59 D.T.C. 247 (T.A.B.).

In summary, although the appellant has established that the use of the borrowed funds has resulted in the acquisition by it of the Smith Township lands, it has failed to show how, given the chosen structure of the transaction, it used the borrowed money for the purpose of producing taxable income. In the result the appeals fail on the main issue. The appeals from the assessments for the 1981 & 1983 taxation years will be dismissed. The appeal from the 1982 determination will, as counsel agreed, be allowed and the matter referred back to the respondent for redetermination by the addition of $12,450 to the non capital loss as referred to in paragraph 5 of the amended notice of appeal.

Appeal dismissed.