Her Majesty the Queen v. Said Mohammad Attaie, [1987] 2 CTC 212, 87 DTC 5411

Collier, J. [Orally]:—This is an appeal from a decision of the Tax Court of Canada. The reasons of Judge Goetz are reported at [1985] 2 C.T.C. 2331; 85 D.T.C. 613. He allowed the defendant taxpayer's appeal.

For his 1980, 1981 and 1982 taxation years, the defendant sought to deduct certain payments of interest. He asserted they were interest amounts paid on borrowed money, used for the purpose of earning income from a business or property. He relied on subparagraph 20(1)(c)(i) of the Income Tax Act, S.C. 1970-71-72, c. 63.

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: . . .

(c) an amount paid in the year or payable in respect of the year (depending upon the method regularly followed by the taxpayer in computing his 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).

The Minister disallowed the deductions.

The facts are clear and not in dispute. The defendant is married with two children. He is a native of Iran. He first came to Canada, without his family, in 1978. He decided to move himself and his family permanently to this country. He looked for a house. In October 1978, he entered into an agreement to buy a home in the Don Mills area of Toronto. The closing date was December 29, 1978. The purchase price was $105,000.

At that time, the defendant had approximately $60,000 in funds. He obtained a mortgage agreement to borrow $54,000 (Exhibit 5). It was to be a fully open mortgage, repayable at any time. The rate was 10 A per cent, a point or two higher than that being charged for traditional closed mortgages. The defendant insisted, over the views of his real estate agent, on paying the higher rate for the open mortgage.

His reason was this. He had approximately $200,000 in funds in Iran. Once he had come to Canada permanently, he expected to be able to move the funds out of Iran within a matter of months, certainly within a year. He intended then to pay out the mortgage.

The mortgage document itself, Exhibit 6, is dated November 21, 1978. The mortgagee was the Municipal Savings and Loan Corporation. The maturity date was November 30, 1983. As had been agreed, the defendant could prepay at any time without notice or bonus.

The defendant returned to Canada in 1979.

The home in Don Mills was rented until the end of May 1980. For those first five months of 1980, the defendant reported, in his tax return, rental income. He deducted expenses in respect of the property. Included as a rental expense was the interest paid pursuant to the mortgage. That interest expense was allowed by the revenue department.

From June 1, 1980, the defendant and his family have occupied the home as the principal residence.

The $200,000 in funds in Iran came to this country in May or June 1979. In that year the interest rate on term deposit investments was substantially higher than the 10 A per cent mortgage interest. The defendant testified he made a conscious business decision not to pay off the mortgage, but to invest the $200,000 in the paper paying higher interest rates.

He did not pay out the mortgage and then borrow once more for purposes of investment. That would not, in his view, have been sensible. He purchased term deposits with various banks. He continued to do so until February 1983.

A list of the deposits was filed as Exhibit 14. It may not be quite complete. Nothing turns on that. For example, a six-month deposit of $136,000 was issued on October 1979, at a rate of 14.25 per cent. Subsequent deposits were issued, probably sometimes rolling over earlier amounts. At all times for the years in question the interest rate received exceeded the 10 A per cent rate on the mortgage. As another example, a six-month term deposit of $37,000, issued on September 9, 1981, paid 19.75 per cent.

At all relevant times, the funds invested in term deposits substantially exceeded the $54,000 on the mortgage.

In his 1980, 1981 and 1982 income tax returns, the defendant declared the interest received from the term deposits. He sought to deduct the interest amounts paid on the borrowed mortgage funds. Those were as follows:

In the early part of 1983, interest rates declined below 10 /4 per cent. The defendant decided to pay off the mortgage loan. He did so on February 28, 1983, in the amount of $52,580.92.

The Tax Court found the interest payments were deductible. At that time, Bronfman Trust v. M.N.R., [1978] C.T.C. 3088; 78 D.T.C. 1752 (T.R.B.) had not reached the Supreme Court of Canada. The Federal Court of Appeal decision was before Judge Goetz. In the Bronfman case, the trust wanted to make a capital allocation to one of the beneficiaries. The market value of some of the capital assets was depressed. The trust borrowed from the bank in order to preserve the income producing assets. It sought to deduct the interest paid on the borrowed money under subparagraph 20(1)(c)(i).

The Minister said no. The Tax Review Board said no. The Trial Division of the Federal Court said no. The Appeal Division, with Mr. Justice Pratte, dissenting, said yes.

His Honour Judge Goetz, before dealing with the Bronfman decision, set out the relevant facts before him in this case. They are, in essence, the same as the facts now before me. Judge Goetz went on at pages 2333-34 (D.T.C. 614-15):

The appellant, in the case before me relies on the decision of the Federal Court of Appeal in Phyllis Barbara Bronfman Trust (supra). That was a case where the trustees of the Bronfman Trust were obligated to make certain allocations to a trust in the relevant taxation years, but rather than encroach upon the trust funds which were earning income, the trustees borrowed money and paid out each year to the trust the amount that they were obligated to pay under the trust, and then they charged the interest on the borrowed money as an expense. Chief Justice Thurlow, in effect says that his attention should not be focused on the use of borrowed money for the capital allocation. He felt that what was important was the effect of such use of borrowed funds. In the Bronfman case (supra), it was to preserve the corpus of the Trust as opposed to this case.

What makes this case different than both the Huber and the Bronfman cases (supra) is, as I pointed out earlier, that the appellant had sufficient funds available to him after having paid interest and principal on his residential mortgage. At that time, he was in the fortuitous position of having a large amount of capital in his hands which he could have deposited and did actually use for the purchase of term deposits on which he earned interest, at the same time he could have paid out the open mortgage on his residential property. I feel that the appellant is in no different position than if the residential property title was clear and he would have been able to, at that point in time, take out a mortgage on the residence and use the funds from that mortgage to earn income from term deposits. Rather than doing that, he took the position that the mortgage funds could be better used in the open market with term deposits. He was happily in a position where he was able to take advantage of a rapidly rising interest rate and, as a result, he decided not to pay off his mortgage, but instead retain the funds that he received from Iran and bought the term certificates.

The fact that the appellant found himself in the position of having money available to take advantage of the rapidly rising interest rates in the open market, to me, puts him in a position where his option of paying out his residential mortgage was dealt with in what I consider a clever and prudent way. If he had tried to borrow money at the point in time, he said the going rates of interest were between 14 and 16 per cent. He would have been foolish in the circumstances to pay off his mortgage and then try to borrow again from whomsoever he borrowed money in the first instance on the residence. Rather, he just let it sit. As I mentioned earlier, had the property been clear, if he had taken out a mortgage for the purpose of purchasing term deposits and charging the interest, he would have been able to do that. I find the appellant in no different position in deciding not to pay out his mortgage at that time. He did pay out the mortgage in 1983 at about the time when the term deposits matured. As the interest rates were going down, there was no advantage to him any longer to maintain the residential mortgage and he paid it out.

The appellant openly declared income in the relevant taxation years on the difference between the mortgage interest rate and the market interest rate. That was his area of income. In his tax returns for the said years, he also declared as a charge the interest rate on the corpus of the mortgage funds. It is somewhat analogous to the Bronfman Trust case (supra), but nevertheless different. To sum it up, the situation was indeed unique. The appellant took advantage of the position in which he found himself and, in my view, he acted quite astutely in doing what he did. His actions were completely open for those relevant taxation years, complete disclosure.

I find on all of the evidence that the deductions that he made on account of the interest on the residential mortgage, under the circumstances — as I say, I repeat unique circumstances of his case — are properly deductible as expenses on funds used for the producing of income from term deposits. I grant the appeal.

The Bronfman case has now been heard and decided in the Supreme Court of Canada, [1987] 1 S.C.R. 32; [1987] 1 C.T.C. 117. The judgment of the Court was delivered by Chief Justice Dickson. The Court held the interest payments were not deductible.

Counsel for the Crown, in this case, relied on the final Bronfman decision, in contending these interest payments are not deductible. Other decisions were, as well, cited to me.

Counsel for the defendant submitted the Bronfman case was distinguishable on its facts; in any event the interest payments here fell within certain principles set out in Bronfman, permitting their deduction.

I have concluded the interest payments made by this taxpayer are deductible under subparagraph 20(1)(c)(i).

In Bronfman, Chief Justice Dickson stated the issue there at page 35 (C.T.C. 119)

The issue is whether the interest paid to the bank by the Trust on the borrowings is deductible for tax purposes; more particularly, is an interest deduction only available where the loan is used directly to produce income or is a deduction also available when, although its direct use may not produce income, the loan can be seen as preserving income-producing assets which might otherwise have been liquidated. A subordinate issue is whether the answer to this question depends upon the status of the taxpayer as a corporation, a trust, or a natural person.

The Chief Justice then went on to state some general principles in repect of the subparagraph of the statute. He pointed out at pages 46-7 (C.T.C. 125), that it is not the purpose of the borrowing itself which is relevant; it is the taxpayer's purpose in using the borrowed money; the current use, not the Original use, is relevant.

Here, the defendant's original purpose was to obtain funds to complete the purchase of the home. Once he received the funds from Iran that use of the borrowed funds, in a practical business sense, ceased. He made a carefully thought-out decision to maintain the borrowing in order to invest in attractive term deposits and earn income. This was done with an eye to the practical commercial and economic realities at the time.

As the Chief Justice said in the Bronfman decision, just as there has been a recent trend away from strict construction of taxing statutes:

. . so too has the recent trend in tax cases been towards attempting to ascertain the true commercial and practical nature of the taxpayer's transactions. There has been, in this country and elsewhere, a movement away from tests based on the form of transactions and towards tests based on what Lord Pearce has referred to as a “common sense appreciation of all the guiding features" of the events in question. . . .

page 52 (C.T.C. 128) and at page 53 (C.T.C. 128):

This is, I believe, a laudible trend provided it is consistent with the text and purposes of the taxation statute. Assessment of the taxpayers' transactions with an eye to commercial and economic realities, rather than juristic classification of form, may help to avoid the inequity of tax liability being dependent upon the taxpayer's sophistication at manipulating a sequence of events to achieve a patina of compliance with the apparent prerequisites for a tax deduction.

I earlier referred to the comments at pages 46-47 (C.T.C. 125) of the report, dealing with the issue of original or current use of the borrowed money.

I now set out in full the passage at page 47 (C.T.C. 125):

V.

Original or Current Use of Borrowed Money

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. Minister of National Revenue, [1973] C.T.C. 586 (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 re-sold 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 (T.R.B.); Attaie v. M. N.R., 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 income-earning property.

The Sinha decision was not appealed. I note the factual pattern there was quite similar to the factual pattern here. The Supreme Court, in that passage, made no adverse remarks about those two decisions.

This defendant has, in my view, brought himself within the converse proposition set out by the Chief Justice.

The appeal is dismissed, with costs.

Appeal dismissed.