Citation: 2009TCC377
Date: 20090724
Docket:
2008-3801(IT)I
BETWEEN:
NINA SHERLE,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Hershfield J.
Background and Issues
[1] This appeal deals
with the deductibility of interest paid by the Appellant in her 2004 and 2005
taxation years on a loan secured by a mortgage on a home which she co-owned
with her husband (“Alan”).
[2] The evidence,
together with unchallenged assumptions of fact made by the Minister, can be
summarized as follows:
(a) The
Appellant and Alan owned a property located on Joyce Street in Vancouver (“the
Joyce Property”);
(b) The Appellant
and Alan purchased the Joyce Property in 1985 and used it as their principal
residence until 1994;
(c)
The
Appellant and Alan owned a property located on Ewart Street in Burnaby (the “Ewart Property”);
(d) The Appellant and Alan
purchased the Ewart Property in 1993 and used it as a rental property until
the middle of 1994;
(e) The Ewart property was rented
to an arm’s length tenant;
(f) During 1994, the
Appellant converted the Joyce Property from their principal residence to a
rental property;
(g) During 1994, the Appellant
converted the Ewart Property from a rental property to their principal
residence;
(h) In April, 1994, the Appellant
and Alan took out a mortgage on the Joyce Property in the amount of $180,000
(prior to that the Joyce Property was owned free and clear of
any debt encumbrance);
(i) In April, 1994, the
Appellant and Alan used the amount of $180,000 to pay the mortgage on
the Ewart Property (placed on the Ewart Property to secure a loan used on its purchase);
(j) In December, 1994,
the Appellant and Alan took out a new loan and credit line secured by a
mortgage on the Ewart Property in the amount of $73,966;
(k) The loan and credit line secured
by the Ewart Property mortgage was unrelated to the change in use of
either of the two properties. The proceeds of the loan were largely used to
make payments on unrelated loans from relatives and for minor renovations
to the Ewart Property after it had become a principal residence;
(l) On January 15,
1995, the Appellant rented the Joyce Property to an arm’s length tenant.
[3] Having listened to
the Appellant’s testimony, I am satisfied that these facts are consistent with
the Appellant’s presentation of them, summarized as follows:
-
a
rental property was owned and interest payable in respect of that property was
deductible;
-
a
personal residence was owned free and clear of any loans;
-
the
Appellant wanted to switch properties; that is, live in the rental property and
rent out the personal residence;
-
she
did not want the switch to alter her financing goal which was to continue being
in a personal residence that was unencumbered by a mortgage;
-
to
effect this, she mortgaged the residence she was leaving to pay off the loan on
the rental property which was to be her new residence;
-
this
resulted in her having interest payments due on a loan secured by a mortgage on
the Joyce property which was the rental property after the switch;
-
the
whole change in use undertaking was conditional on realization of her objective
to maintain her equity in her personal residence;
-
that
she later took out a mortgage on her new residence (the Ewart Property), as
circumstances required, should not be relevant in considering the true purpose
of the loan secured by the mortgage on the new rental property (the Joyce
Property);
-
that
purpose was to finance the holding of an income producing asset.
Arguments
[4] The Appellant
argues that the purpose of borrowing on the security of her former residence
was to enable the switch of properties and to thereby enable the desired
change of use of the Joyce Property to a rental property. Without such
financing, the “switch” would not have been acceptable. The Joyce Property loan
was therefore required to effect the change of use which led to that property
becoming an income-producing one. The Appellant relies on subparagraph
20(1)(c)(i) of the Income Tax Act (the “Act”) which
sets out the requirement that for interest on borrowed funds to be deductible,
the borrowed funds must be used for the purpose of gaining or producing income.
[5] The Respondent
argues that the actual use of the monies borrowed was to pay off a
mortgage on the Appellant’s new personal residence and that therefore the
borrowed money cannot be viewed as giving rise to interest incurred to gain or
produce income. The Respondent relies on case law authorities to the effect that
the deductibility of interest under subparagraph 20(1)(c)(i) of the Act
is governed solely by the actual, direct use of the borrowed funds, and that
the use of the loan proceeds indirectly enabled or resulted in the Appellant
having a new income producing property is not relevant.
Analysis
[6] The requirements
for interest to be deductible are set out in section 20 of the Act which
reads in its relevant parts as follows:
20(1) Deductions permitted in
computing income from business or property -- 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:
[…]
(c) interest -- an amount paid in the year or payable in respect of the year (depending upon the
method regularly followed by the taxpayer in computing the taxpayer's 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),
(ii) an amount payable for property acquired for the purpose of gaining or
producing income from the property or for the purpose of gaining or
producing income from a business (other than property the income from which would be
exempt or property that is an interest in a life
insurance policy),
[…]
or a reasonable amount in respect thereof,
whichever is the lesser;
(Emphasis
added.)
[7] As noted, subparagraph
20(1)(c)(i) permits the deduction of interest on borrowed money only if the
borrowed funds are used for the purpose of gaining or producing income.
[8] The Respondent
relies on Singleton v. Canada, [2001] 2 S.C.R. 1046 (“Singleton”)
and Lipson v. Canada, [2009] 1 S.C.R. 3 (“Lipson”) as
confirming that the direct and immediate use of borrowed money is the only
factor to be considered in ascertaining the purpose of the loan.
[9] In Singleton,
a taxpayer refinanced his partnership interest (an income- producing asset)
with a loan reflected largely by book entries, thereby permitting a tax free
withdrawal of funds from that partnership. That is, his former capital
investment in the firm was taken out and replaced with borrowed money. The
funds so withdrawn were used to buy a home. It was clear from the facts that
the ultimate purpose of the loan was to permit the purchase of a home; however,
the direct use of the borrowed monies was to refinance an income producing
asset by making a capital contribution to the partnership.
[10] Justice Bowman of
this Court (as he then was) found that the true purpose of the loan was to
finance the purchase of a home, and so he denied the interest deduction. In his
decision he
remarked as follows:
12 On
any realistic view of the matter it could not be said that the money was used
for the purpose of making a contribution of capital to the partnership. The
fundamental purpose was the purchase of a house and this purpose cannot be
altered by the shuffle of cheques that took place on October 27, 1988.
[…]
14 The
true purpose of the use of the borrowed funds subsumed the subordinate and
incidental links in the chain. Theoretically one might, in a connected
series of events leading to a predetermined conclusion, postulate as the
purpose of each event in the sequence the achievement of the result that
immediately follows but in determining the "purpose" of the use of
borrowed funds within the meaning of paragraph 20(1)(c) the court is faced with
practical considerations with which the pure theorist is not concerned.
(Emphasis added.)
[11] Under this view, the
Appellant would have a better chance to succeed in her appeal. Her true purpose
was to refinance her holdings, by borrowing funds, in order to permit her to
earn rental income from a property that had not, prior to the borrowing,
produced any income. As an income producing property, the Joyce Property was,
in effect, newly acquired. Indirectly, the borrowed money was used for the
overall purpose of producing income from a newly acquired property. However, this
view as to the proper construction of the purpose test in paragraph 20(1)(c)
did not prevail.
[12] The case went from
this Court to the Federal Court of Appeal and finally to the Supreme Court of
Canada and was heard, in that process, by a total of 11 judges. Four such
judges found, in effect, that the only bona fide purpose of the loan was
to finance the purchase of the house and that the interest on the loan was not
deductible. At the end of the road however, 5 of 7 Supreme Court judges found
the overall purpose of the loan was not the governing factor in applying
paragraph 20(1)(c). Justice Major, who authored the decision of the majority at
the Supreme Court, reasoned as follows:
26 […]
The Shell case [Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622]
confirmed that the focus of the inquiry is not on the purpose of the
borrowing per se, but is on the taxpayer's purpose in using the money.
McLachlin J. agreed with Dickson C.J. in Bronfman Trust that the inquiry
must be centred on the use to which the taxpayer put the borrowed funds.
McLachlin J. made it clear that the deduction is not available where the link
between the borrowed money and the eligible use is indirect. However, she made
it equally clear that "[i]f a direct link can be drawn between the
borrowed money and an eligible use" this third element is satisfied (para.
33).
[…]
29 It is now plain from the reasoning in Shell that the
issue to be determined is the direct use to which the borrowed funds were put.
[…]
(Emphasis added.)
[13] In the context of
the present appeal then, the overall purpose of the Appellant’s loan, namely to
have a financing arrangement enabling the change in use of a personal use property
to an income-producing property, is not the governing factor. The relevant
question is: to what direct use were the borrowed funds put?
[14] The Appellant has
admitted that the proceeds of the loan secured by the Joyce Property were used
to pay down the mortgage on the Ewart Property. This property was converted by
the Appellant into their principal residence in 1994. Since this change
resulted in the Ewart Property becoming incapable of producing income, the direct
use of the funds does not fit within the requirements of subparagraph
20(1)(c)(i), as that provision has been interpreted by the Courts. Therefore,
the Appellant is not entitled to the interest deduction she seeks.
[15] I also point out in
support of this conclusion that the Appellant’s focus as to “why” she borrowed
the money is itself misdirected given the Court’s construction of the requirements
of subparagraph 20(1)(c)(i). There is no dispute as to why she used the loan
proceeds as she did: namely, it was to maintain in her new residence the same equity
she had in her former residence. She wanted to change the use of a property
from a non-income producing asset to an income producing asset without
negatively impacting her financial situation vis-à-vis her equity in her
residence. This required her to use the loan proceeds to increase her equity in
her new residence. However, the law is clear that “why” funds are borrowed is
irrelevant to the analysis under subparagraph 20(1)(c)(i). It is the use of the funds that
governs. In the present case, the required link between the use of the proceeds
and the income producing property is just not there.
[16] While this
conclusion does not sit easily with my reading of the subject provision, the
authorities that bind me are clear. Distinguishing these authorities and
resurrecting this Court’s decision in Singleton would make the
administration of the subject provision more difficult than it already appears
to be. The law relies on the consistent application of the principles developed
by the higher Courts and I am bound to follow them.
[17] Before concluding,
there are a few additional matters that I would like to address.
[18] Firstly, in addition
to relying on subparagraph 20(1)(c)(i), the Appellant wanted me to address her
interest deduction claim under subparagraph 20(1)(c)(ii) given that, pursuant
to section 45 of the Act, a deemed acquisition of the Joyce
Property occurred due to the change in its use.
[19] In responding to
this, it is helpful to look at the two provisions together:
20(1) […] there may be deducted […]
(c) interest -- an amount paid in the year or payable in respect of the year (depending upon the
method regularly followed by the taxpayer in computing the taxpayer's income), pursuant
to a legal obligation to pay interest on
(i) […]
(ii) an amount payable for property acquired for the purpose of gaining or
producing income from the property or for the purpose of gaining or producing
income from a business (other than property the income from which would be
exempt or property that is an interest in a life
insurance policy),
[…]
(Emphasis added.)
45(1)
Property with more than one use [change in use] -- For the purposes of this subdivision the
following rules apply:
(a) where a
taxpayer,
(i)
having acquired property for some other purpose, has
commenced at a later time to use it for the purpose of gaining or producing income, or
(ii)
having acquired property for the
purpose of gaining or producing income,
has commenced at a later time to use it for some other purpose,
the taxpayer shall be
deemed to have
(iii)
disposed of it at that later time for proceeds equal to its fair market value
at that later time, and
(iv)
immediately thereafter reacquired it at a cost equal to that fair market value;
(Emphasis added.)
[20] These provisions
read together do not assist the Appellant in this case. Subparagraph
20(1)(c)(ii) allows interest to be deducted if it is paid “on an amount
payable for property acquired”. That is, it allows interest to be deducted
in respect of an obligation arising as payment for (as part of) the purchase
price of the property acquired. The deemed acquisition of the income-producing
property, in this case, does not give rise to a principal amount payable.
Therefore, the interest paid by the Appellant cannot relate to such a
non-existent amount. It relates to the loan used to pay off the mortgage on the
Ewart Property - a property that is not income-producing. That the deemed
acquisition might not have occurred but for the refinancing employed cannot
make the actual loan obligation amount an amount “payable for property
acquired”.
[21] Secondly, it should
be noted that the nature of the security given for a loan is not relevant in
determining whether interest payments in respect of that loan are deductible
from income. In the present case, the fact that the security given for the loan
was an income-producing rental property is not sufficient to meet the
requirements of subparagraph 20(1)(c)(i). Giving the rental property as
security for a loan does not attach (connect) the interest payment on the loan
to the income stream from that rental property. The nature of the security for
the loan is not merely a tenuous link to the use of the loan proceeds - it is simply
not relevant in considering how the loan proceeds are used.
[22] Thirdly, I note that
the Appellant has effectively underlined an unsettling ironic twist to the
Respondent’s position. I would not be doing her justice unless I recognized her
point. The twist is that what was of concern in Singleton was that the
series of steps adopted obscured reality; they obscured the real bona fide
purpose of the loan. In the case at bar, doing what Singleton did would not
disguise the real purpose of the loan but would rather ensure recognition of
it. Namely, a Singleton-type series of contrived and purely legalistic
steps would ensure that her underlying purpose would be recognized under
paragraph 20(1)(c). Such a connected series of steps would not be subordinate,
incidental links that are subsumed by the true purpose. They would be insurance
that the true purpose would be recognized.
[23] Indeed, the
Appellant argued, without particular knowledge of the plan in Singleton,
that she could have sold the residence to a friend and bought it back and
achieved the desired result. For example, with the necessary legal advice, the
Appellant might have done something along the following lines:
·
On
day 1 she sells her residence, the Joyce Property, to her friend Ms. A. The
purchase price is paid by issuing a Promissory Note;
·
On
day 2 she takes a bank loan to discharge the mortgage on the Ewart Property (the
first loan). While the loan might only be a daylight-bookkeeping entry, there
is adequate security for it given that a collateral charge will be immediately
available on the Ewart Property upon the payout of the former charge against
it;
·
Also
on day 2, she buys back the Joyce Property (her new rental property), and
finances this acquisition by borrowing money from the bank, which loan is
secured by a mortgage on the re-acquired property (the second loan);
·
The
proceeds of the latter mortgage are paid to her friend Ms. A as consideration
for this buy-back and Ms. A uses the proceeds to pay off the Promissory Note she
issued on the purchase of the property the day before;
·
The
proceeds from the Promissory Note are used by the Appellant to pay off the
first bank loan;
·
The
only remaining loan is the second loan taken to acquire a rental property;
·
Everything
is done at fair market value without tax consequence, and actual transfers of
land need never be registered.
[24] Since in this hypothetical
scenario the direct use of the borrowed funds would be to buy the rental
property, applying the Singleton test of direct use would most likely
result in the interest on such borrowing being deductible. In light of Singleton,
it would be difficult to suggest that this series of transactions would be
considered artificial or lacking commercial reality in some fatal way. Considering
the Supreme Court decision in Lipson it would be difficult to even
suggest that this hypothetical series of transactions could be found to be offside
the General Anti-Avoidance Rule in section 245 of the Act.
[25] The result then is
that had the Appellant engaged in this type of tax planning, applying the
direct use test would give the same result as that which could have been
achieved without such a plan if the construction of subparagraph 20(1)(c)(i)
recognized the ultimate or true purpose of the loan.
[26] A further irony in
this situation lies in one of the rationales of the majority in Singleton
that allowed the interest deduction in that case. That rationale is found at
paragraphs 37 and 38 of Justice Major’s majority decision:
37 In
Bronfman Trust, it was stated that "[f]airness requires that the
same legal principles must apply to all taxpayers, irrespective of their status
as natural or artificial persons, unless the Act specifically provides
otherwise" (p. 46). As indicated by this statement, if a corporation can
refinance equity with debt and deduct the interest on the associated debt, so
too should the respondent be entitled to refinance his partnership equity with
debt and deduct the interest.
38 If the respondent
was not allowed to do this we would end up with the inconsistency identified by
Rothstein J.A. That is, the interest would be deductible where a partner's
initial capital investment was financed with borrowed funds. As well, it would
continue to be deductible with a subsequent refinancing of debt. However, a
partner who originally financed with his own money and later withdraws that
money for personal use and refinances with debt would be denied the deduction.
[27] Based on this
horizontal equity justification of respecting legal form, one might have
thought a similar justification could allow for the recognition of the true
purpose of a loan in a case such as the one at bar. Indeed, the Appellant’s
plea is that I recognize that she is being put in a worse economic position
than someone who had debt financed a rental property when it was first acquired,
and that, like in Singleton, I should resolve that inequity. In effect,
her plea is that the proper construction of the subject provisions be informed,
on the facts of her case, by a fundamental principle of our taxation system: two
persons in similar circumstances should be subject to the same burden of
taxation. She asks that I recognize her ultimate economic picture as the means
by which I can do that.
[28] However, that option
is not open to me. Both the Supreme Court decisions in Shell and Singleton
make it clear that the focus for the application of the subject provision is on
the direct “use” of the borrowed money as opposed to the “purpose” for
borrowing it or the ultimate economic result of borrowing it.
[29] In assessing the use
of borrowed money, it is not open to the Court to re-characterize a taxpayer’s bone
fide legal relationships so as to allow the “economic realities” of that
taxpayer’s situation, objectively or subjectively determined, to govern the
analysis. Absent a specific provision of the Act to the contrary or a
finding that the transactions that were carried out were a sham, a taxpayer’s
legal relationships will be respected in tax cases.
[30] At the end of the day, a taxpayer is not
able to simply argue that the economic substance of their situation is identical
to that of another taxpayer and thereby claim to be entitled to a tax treatment
similar to that enjoyed by that other taxpayer. This was most recently
illustrated in Scragg v. Canada, [2009] F.C.J. No. 710, 2009 FCA 180. In
that case, the taxpayer borrowed $150,000 from a business associate and claimed
the money was to fund his companies. At trial, it was determined that there was
insufficient evidence to demonstrate that the funds had actually been used for
this purpose. In affirming the decision below, Justice Noël reasoned as follows
at paragraph 12:
12 The
appellant compared his case to that of Singleton v. Canada, 2001 SCC 61,
[2001] 2 S.C.R. 1046 in which a taxpayer who used borrowed funds to replace
equity taken from his law firm to purchase a house was allowed the interest
deduction on the borrowed funds. The comparison is not apt because in Singleton,
the taxpayer was clearly able to trace the borrowed fund to an eligible use. The
appellant’s argument is that the only difference between his case and Singleton
is that he did not bother with the formalities, that is, he did not withdraw
his equity from his companies and replace it with borrowed money, but in
substance his transaction achieves the same result. With respect, it does not.
A taxpayer cannot deduct interest on borrowed money unless the money is
actually used to produce income. It is not enough to say that it could have
been, as the appellant says here.
(Emphasis added.)
[31] Similarly,
Justice McLachlin stated in Shell, at paragraph 45:
45 […] Unless the Act provides otherwise, a
taxpayer is entitled to be taxed based on what it actually did, not based on
what it could have done, […].
[32] As well, I note that
to widen the scope of subparagraph 20(1)(c)(i) to allow claims on the basis of
either legal form and ultimate purpose would be to develop a rule that would
permit attribution of all debt firstly to income producing assets and secondly
to personal assets. There is no suggestion in the Act that Parliament
intended such a regime even if the Courts have recognized that steps can be
taken by a taxpayer to ensure that result. Those steps however must be taken.
[33] Lastly, as alluded
to earlier in these Reasons, I note that while the conclusion I have come to in
this case does not sit easily, distinguishing the authorities would utterly
confuse the administration of the subject provisions and their consistent
application.
[34] For all these
reasons, the appeal is dismissed, without costs.
Signed at Ottawa, Canada this 24th day of July 2009.
"J.E. Hershfield"
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