Aitchison v. The Queen, 98 DTC 1956, [1995] 2 CTC 2558 (TCC)

Sobier J.T.C.C.:—The appellant appeals from the assessments by the Minister of National Revenue (the "Minister") for her 1991 and 1992 taxation years, whereby the Minister denied her claim for interest expense for those years.

The appellant did not appear or give evidence. Her son, James N. Aitchison, acted as her agent and was the appellant’s sole witness.

Mr. James Aitchison is a practising solicitor who also deals in mortgages through LMA Investments Ltd. ("LMA"), a corporation controlled by he and his wife. LMA deals in second and third mortgages of a somewhat higher risk which results in their bearing a higher rate of interest.

In October 1987, the appellant subscribed for 750 special shares of LMA at $100 per share, for a total of $75,000. The $75,000 was borrowed from Guaranty Trust Company of Canada ("Guaranty Trust"), and was secured by a charge on her home, which was then otherwise free and clear of encumbrances.

It is the deductibility of the interest paid on this loan from Guaranty Trust in 1991 and 1992 which is in issue.

In 1987, 1988, 1989 and 1990, dividends were paid to the appellant by LMA.

In 1991, Mr. Aitchison claims to have become aware that as a result of the downturn of the economy, especially in the real estate field and because of the solvency tests contained in the Ontario Business Corporations Act, LMA would not be in a position to pay dividends. It was Mr. Aitchison’s plan therefore to cause LMA to redeem the appellant’s special shares for $75,000 and to use the proceeds of the redemption to purchase mortgages or interests in mortgages from LMA in a like amount.

Counsel for the respondent contends that there is no evidence that the proceeds of the redemption were used to purchase the mortgages. This being so, he argues that the originally borrowed funds cannot be traced or followed to the mortgages, and therefore the interest payable thereon is not deductible. I am satisfied that because of the dating of the documents and the apparent sequence of events, that the monies owed by LMA for the redemption price were used to satisfy the purchase price for the mortgages.

Counsel for the respondent also put a great deal of weight on the fact that the stated consideration for the assignments of the mortgages was on the face of the assignments, ($2 in each case), and that the stated consideration was all the appellant invested. This style of stating consideration as a nominal amount is common in deeds and mortgages and is not meant to show the actual consideration paid. Both of these arguments therefore fail.

That interest paid on the money borrowed were properly deductible in 1987, 1988, 1989, 1990 taxation years is not disputed. The deduction of the interest payments in the 1991 and 1992 taxation years was disallowed by the Minister. The disallowance was based on the argument that the interest paid on the Guaranty Trust loan in 1991 and 1992 was not paid on money borrowed and used for the purpose of earning income from a business or property. It is the Minister’s contention that since the interest expense in those years exceeded in the interest income from the mortgages, interest was not paid to earn income from property. In support of this position, counsel for the respondent referred to D.M.R. (Qué.) v. Lipson, [1979] 1 S.C.R. 833, [1979] C.T.C. 247, 79 D.T.C. 1222. This appeal dealt with the provisions of sections 5 and 15 of the Provincial Income Tax Act, R.S.Q. 1964 c. 69, which provisions are identical to subsection 9(1) [1] and paragraph 18(l)(a) [2] of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act”) which are applicable to the within appeal. (See also subparagraph 20( 1 )(c)(i). [3] In particular, counsel referred to a portion of the reasons for judgment of Pigeon J. at page S.C.R. 839 (C.T.C. 250) of Lipson, where after setting forth the provisions of section 5 and paragraph 15(a) of the Quebec statute, he goes on to say:

It is perfectly clear from these provisions that, in order for an expense to be admissible as a deduction from a taxpayer’s income, it must have been incurred in order to make a profit. It is not enough that the expense was incurred in order to obtain gross income, as counsel argued at the hearing. By virtue of section 5, to gain income means to yield a profit.

[Emphasis in original.]

I cannot agree with counsel that this statement categorically means that if there is no profit, there is no deductibility of interest. Lipson can be distinguished from the present appeal, since in Lipson there was never any possibility of a profit on the lease in question during the years under appeal. The scheme there was for the appellant to deduct his portion of the loss suffered by the syndicate. Here, we have a history of income through dividends and in the years under appeal, the real possibility of substantial income from interest payable on the mortgages. Had this interest been paid in accordance with the terms of the mortgages, there would have been an excess of interest income over interest expense.

At the time of the conversion of the investment from shares to mortgages, the appellant had every right to believe that there would be sufficient income. This was dealt with in Tennant v. Canada, [1993] 1 C.T.C. 148, 93 D.T.C. 5067 (F.C.T.D.), affirmed by the Federal Court of Appeal in Tennant v. Canada, [1994] 2 C.T.C. 113, 94 D.T.C. 6505. At page 157 (D.T.C. 5073) of Tennant, Mr. Justice Teitelbaum of the Trial Division, stated:

In my opinion, the language of paragraph 20(1 )(c) is not ambiguous when read in conjunction with subsection 20(1). It is clear that the amount borrowed by the taxpayer must relate to a source from which the taxpayer has a reason- able expectation of profit.

The source of course in this appeal was the mortgages, and far from requiring that profit be a must, I must agree with Mr. Justice Teitelbaum that the taxpayer need only have a reasonable expectation of profit and from the evidence, I find that she did.

The change of the investment from shares to mortgages did not affect the deductibility of the interest. This is consistent with the reasons for judgment in Bronfman Trust v. The Queen, [1987] 1 C.T.C. 117, 87 D.T.C. 5059 (S.C.C.). Chief Justice Dickson said at page 124-125 (D.T.C. 5064):

The cases are consistent with the proposition that it is the current use 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 Corp. 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 incomeearning property which could be resold immediately without affecting the deductibility of interest payments for an indefinite period thereafter.

Conversely, a taxpayer who uses or intends to use borrowed money for an ineligible purpose, but later uses the funds to earn non- exempt income from a business or property, ought not to be deprived of the deduction for the current, eligible use: Sinha v. M.N.R., [1981] C.T.C. 2599, 81 D.T.C. 465 (T.R.B.); Attaie v. M.N.R., [1985] 2 C.T.C. 2331, 85 D.T.C. 613 (T.C.C.) (presently under appeal). For example, if a taxpayer borrows to buy personal property which he or she subsequently sells, the interest payments will become prospectively deductible if the proceeds of sale are used to purchase eligible incomeearning property.

There is, however, an important natural limitation on this principle. The borrowed funds must still be in the hands of the taxpayer, as traced through the proceeds of disposition of the preceding ineligible use, if the taxpayer is to claim the deduction on the basis of a current eligible use. Where the taxpayer has expended the borrowings on an ineligible use, and has received no enduring benefit or saleable property in return, the borrowed money can obviously not be available to the taxpayer for a subsequent use, whether eligible or ineligible. A continuing obligation to make interest payments to the creditor therefore does not conclusively demonstrate that the borrowed money has a continuing use for the taxpayer.

This passage is unequivocal. Even if there is a change of use, if the new use continues to be for the purpose of earning income from a business or a property, the taxpayer will be entitled to deduct the interest paid.

As for tracing the borrowed funds I refer to the earlier portion of these reasons, where I determined that the funds flowed from Guaranty Trust to Mrs. Aitchison, then to LMA to purchase special shares. This flow con- tinued with the redemption of the special shares and the purchase by the appellant from LMA of the mortgages, using the proceeds of redemption to satisfy the purchase price for the mortgages.

That the mortgages later did not produce the expected income matters not. It is not the fact of income but the reasonable expectation of earning this income which matters.

For these reasons, the appeals are allowed with costs, and the matter referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that the income expense claimed in the 1991 and 1992 taxation years be allowed.

Appeals allowed with costs.