Pierre Grenier v. Minister of National Revenue, [1992] 1 CTC 2703, 92 DTC 1678

Lamarre Proulx, T.C.C.J.:—This is an appeal concerning the 1987 taxation year. The issue is whether the interest paid on a hypothecary loan taken in order to purchase a private residence may be deducted against the appellant's income. This hypothecary loan followed a prior hypothecary loan in a lower amount which had been taken in order to finance a loan to a corporation in which the appellant was the principal shareholder.

The facts

The appellant, who resides in Rosemere, held 50 per cent of the interest in an automobile garage in Mascouche since 1977. In August, 1985, he sold this interest and became the principal shareholder in a corporation which owned an automobile garage in Hull. In return for its financial participation, the bank required the shareholders to invest funds in the form of shareholder advances to the corporation. The appellant's share amounted to $156,000. In order to pay this sum, the appellant used the $90,000 proceeds he received from the sale of his interest in the Mascouche garage. To make up the difference, he granted a hypothec on his house in Rosemere, which at the time was unencumbered by any hypothecs, in the amount of $66,000.

Because the appellant's new place of work was in Hull, the Rosemere house was sold; the sale price was $110,000. The day after that sale, the appellant purchased another residence in Gatineau, near Hull, for $167,361.64. When the first house was sold, the $66,000 hypothec was repaid out of the proceeds of sale. According to the appellant, the bank required the appellant to proceed in this manner. The hypothec granted on the second house was in the amount of $151,700.

The interest, the deduction of which is in issue, is the interest paid on the hypothecary loan of $151,700 which was used to purchase the Gatineau residence.

Appellant's position

Counsel for the appellant argued that the interest paid on the hypothec on the appellant's residence may be deducted under paragraph 20(1)(c) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act"). This

paragraph provides that a taxpayer may deduct interest paid on money borrowed and used for the purpose of earning income from a business or property.

Counsel for the appellant submitted that the $151,700 replaced the $66,000 loan. Counsel for the appellant suggested that the $66,000 was refinanced by the $151,700. He argued that the appellant was in a situation that was analogous to that in Trans-Prairie Pipelines v. M.N.R., [1970] C.T.C. 537, 70 D.T.C. 635.

Counsel for the appellant also relied on subsection 20(3) of the Act. This subsection reads as follows:

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 (1)(c)(n) previously acquired,

the borrowed money shall, for the purposes of section 21 and paragraph (1)(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.

Respondent's position .

Counsel for the respondent did not question the appellants right, to deduct interest paid on the first hypothecary loan of $66,000, in computing his

income. This aspect is therefore not in dispute. Her argument was based on the decision of the Supreme Court in Bronfman Trust v. The Queen, [1987] 1

S.C.R. 32, [1987] 1 C.T.C. 117, 87 D.T.C. 5059. She argued that since the $66,000 loan was repaid when the first house was sold, the purpose of the subsequent $151,700 loan cannot be considered to have been for the financing of the business, but solely to purchase a residence.

Analysis

in Bronfman Trust, according to the summary of the case, at issue here was whether an interest deduction is only available where the loan is used directly to produce income, the loan can be seen as preserving income-producing assets which might otherwise have been liquidated”.

In the case, the trustees preferred to borrow money to make a payment rather than sell income producing property of the trust. The

that the money borrowed had not been used to earn income. The decision in Bronfman Trust does not seem to have overruled the reasoning inTrans-Prairie Pipelines (Footnote 1, at page 542 (D.T.C. 6354)) with respect to circumstances where loans are replaced with subsequent loans. That reasoning was as fol- lows:

Surely, what must have been intended by paragraph 11(1)(c) was that the interest should be deductible for the years in which the borrowed capital was employed in the business rather than that it should be deductible for the life of a loan as long as

its first use was in the business.

As a result of those transactions, the $700,000 had been repaid to those shareholders and the appellant had borrowed $700,000 which, as a practical matter of business common sense, went to fill the hole left by redemption of the $700,000 preferred.

Referring to the remarks of Mr. Justice Dickson, I am of the opinion that the decision in Bronfman Trust does not overrule the principles in Trans-Prairie Pipelines:

The respondent Trust prefers the decision of Jackett P in Trans-Prairie. In that case, as I have already indicated, Jackett P relied on the proposition, perfectly correct in so far as it goes, that it is the current use and not the original use of borrowed money that determines eligibility for a deduction. As stated previously, however, the fact that the taxpayer continues to pay interest does not inevitably lead to the conclusion that the borrowed money is still being used by the taxpayer, let alone being used for an income-earning purpose. For example, an asset purchase remains unpaid.

With the exception of Trans-Prairie, then, the reasoning of which is, in my opinion, inadequate to support the conclusion sought to be reached by the respondent Trust, the jurisprudence has generally been hostile to claims based on indirect, eligible uses when faced with direct but ineligible uses of borrowed money.

(Footnote 2, at page 128 (D.T.C. 5066, S.C.R. 52))

Is this a case where the principles set out in Trans-Canada Pipelines should be applied, that is, that the interest should be deductible in the years in which the borrowed money was used to earn income, and the deduction not be dependent upon the existence of the first loan contract when there is a subsequent loan contract under which the borrowed money may continue to be used in the business?

I am of the opinion that the answer should be in the affirmative with respect to the amount of $66,000, and the recent decision of Mr. Justice Strayer in The Queen v. J. Shore [1992] 1 C.T.C. 34, 92 D.T.C. 6059, dated January 2, 1992, confirms this conclusion. In circumstances which were analogous to those in the case at bar, the learned judge held that subsection 20(3) of the Act applied and decided in favour of the taxpayer.

This decision affirmed the decision of Judge Taylor of this Court, which is reported at [1986] 1 C.T.C. 2360, 86 D.T.C. 1253. I quote from the summary of that case which appears at page 2361 (D.T.C. 1253):

The taxpayer borrowed approximately $40,000 secured by a mortgage on his residence. He immediately loaned the money to a business corporation controlled by him with the repayment terms being the same as those in the mortgage. Since the interest received by the taxpayer from the company was taxable and the mortgage interest paid by the taxpayer was deductible, the net effect on the taxpayer's income was nil. In 1979 the taxpayer sold his residence with the purchaser assuming the mortgage. A short time later, the taxpayer purchased a new residence and assumed an existing mortgage which also had an outstanding balance of $40,000. The taxpayer continued to include the interest received by the company in his income and to deduct the mortgage interest.

I quote from Mr Justice Strayer, at page 35 (D.T.C. 6060-61):

Each case must turn on its own facts when a court is obliged to make such a characterization. In the present case when one looks at the commercial reality of the situation one sees that there was a series of transactions the net result of which was to enable the taxpayer to borrow money in order to earn income from his business, using his private homes as collateral for the loan. It is important to note that at the beginning of these transactions the taxpayer and his wife were owners of their Thamesford home.

It is not disputed that the taxpayer and his wife gave a mortgage on their home to Guaranty Trust in order to raise approximately $42,000 to use in their new business, Joline Automobiles Ltd and that the net proceeds of that mortgage were loaned to the business.That amounted to a direct use of the money for purposes of the business.

They found a house in Stratford which was encumbered by a mortgage of a similar amount to the mortgage on their previous house, and they were thus able to pay cash to mortgage to acquire the house in Stratford. In my view the reality of that transaction, in taking on a house encumbered by the mortgage in favour of Victoria and Grey Trust similar to the one on their previous residence, was in essence the replacement of one borrowing of money for the purpose of their business by another borrowing of money for the same purpose, thus bringing it within subsection 20(3) of the Income Tax Act so that such "borrowed" money could be deemed to be used for the same purpose as the original money borrowed from Guaranty Trust.

In the case at bar, the hypothec granted on the second house was not in the same amount as the hypothec on the Rosemere house. Perhaps it would have been preferable to grant two hypothecs, one of which would have been in the amount of $66,000. I cannot, however, find that this was essential.

I believe that we must consider the economic context of the transactions in question. When the taxpayer sold his first house, he received $110,000 cash less $66,000. Why did he not receive the full amount of $110,000? This was because part of the amount had been lent for the financial support of his business, which was an automobile garage. When the time came to purchase his other house, he did not have the full $110,000 in hand, again because the money was used in the business. The reason he mortgaged his second home by $66,000 and more is that he did not have the, $66,000 he had lent to the business. In Trans-Prairie Pipelines, the replacement of borrowed money by other borrowed money concerned the corporation only. In the case at bar it involves an individual who borrowed money to earn income by lending this money to a corporation. He had to pay off the first loan secured by a hypothec on his house, because he sold the house. However, when he bought another house, he had to borrow money to make up for the decrease in his assets brought about by the loan to his business, or in other terms, to fill the hole left in his assets by the money he had lent to his business and that was still being used to earn income.

However, I find it difficult to understand the appellant's argument with respect to the full $151,700. The taxpayer may think that he could have used the $90,000 from the sale of his business in Mascouche to acquire the new residence and finance the loan to the corporation entirely through a loan secured by a hypothec on his new residence. This was not done and nothing can change the fact that the loan to the corporation was arranged in part with the cash in hand from the sale of the garage in Mascouche and in part with the proceeds of the hypothecary loan on the first residence.

While the amount of the loan to the corporation was $156,000, the taxpayer cannot claim a deduction for interest on any amount over $66,000, since the loan to the corporation was not financed in the first place entirely by a hypothecary loan. For the reasons set out above, I believe that it may be said that part of the second hypothecary loan was used to replace the $66,000 loan, on the principles stated in Trans-Prairie Pipelines.

However, as to the remainder, it is clear that the funds borrowed were used to purchase a residence, and that the principles stated in Bronfman Trust must apply.

Because the Minister did not dispute that the taxpayer could deduct the interest paid on the first $66,000 loan, the appeal is allowed, with costs, and the matter is referred back to the Minister for reassessment, taking into account that the taxpayer may deduct the interest paid on $66,000 of the hypothecary loan.

Appeal allowed in part.