Erskine v. R., [1999] 4 CTC 2559, 99 DTC 1182

Margeson 1.C.J.:

The Appellant filed Notices of Appeal with respect to the 1987, 1988, 1989, 1990, 1991 and 1992 taxation years under court file number 97- 3125(IT)G and also filed appeals with respect to the 1993, 1994 and 1995 taxation years under court file number 98-153(IT)G.

Initially, there were a considerable number of issues which were contested. However, after considerable and reasonable discussions between counsel, all of the issues with the exception of one were resolved by consent to judgment. Consequently, the appeal will be allowed and the matter sent back to the Minister of National Revenue for reassessment and reconsideration, based upon the consent to judgment filed in this action with respect to the issues that were consented to.

The outstanding issue is in relation to the settlement funds paid by the Appellant to his former spouse pursuant to a separation agreement, an amount of $259,758.20 US or $296,488.00 CDN. The Minister disallowed interest on the amount of the loan which was used to pay the Appellant’s obligations under the separation agreement.

The following represents an Agreed Statement of Facts, edited by the Court, on the basis that only the facts as recited herein are relevant to the one remaining issue. Other facts set out in the Agreed Statement of Facts (Amended) are not inserted in these Reasons for Judgment in light of the consent to judgment on the other outstanding issues.

Charles N. Erskine (the “taxpayer”) was married to his wife at Belmont, California on June 1, 1969. The taxpayer is a United States citizen. The taxpayer and his wife became resident in Canada in 1984 and were resident in Canada during the years under appeal.

During the years in question, one of the taxpayer’s assets was an apartment building located in California known as the “Samson Street Apart- ment”. Rental income from the Samson Street Apartment formed a portion of the taxpayer’s income during the years in question. At all times, the Appellant was the sole registered owner of the Samson Street Apartment property.

The taxpayer and his wife were divorced by an Order of the British Columbia Supreme Court pronounced on May 18, 1990.

On about March 15, 1991, the Appellant and his former spouse entered into an agreement whereby, inter alia, the Appellant agreed to pay his former spouse the sum of $300,000.00 in consideration of which the former spouse agreed to waive all right, title and interest to the Appellant’s assets, including, but not limited to, the Samson Street Apartment.

In 1991, the Appellant refinanced the mortgage registered against the Samson Street Apartment, borrowing proceeds of US $600,000 (CDN $687,480.00) (the “Loan Proceeds”). The exchange rate in 1991 was $1.1458 CDN equals $1.00 US.

The Appellant applied part of the Loan Proceeds to pay out his former spouse pursuant to the separation agreement in the amount of $259,758.20 US or $296,128.00 CDN.

The Appellant paid financing fees with respect to these borrowings in the amount of $11,935.60 US or $13,675.00 CDN.

Revenue Canada disallowed a portion of this interest as non-deductible.

The Appellant obtained an appraisal of the Samson Street Apartment which estimated the fair market value of the property as of February 1, 1991 at $1,550,000.00.

The Appellant and his former spouse obtained an appraisal of the furnishings at 9205 Jura Road and 2747 Grosvenor Road, as at November 30, 1998, the Jura Road furnishings were valued at $8,739.50.

The Appellant obtained an appraisal of the 9205 Jura Road property which estimated the fair market value of the property to be $203,000.00 as at March 1, 1989.

All terms of the Agreement dated March 15, 1991 were met.

The taxpayer received a quit claim deed from his former wife in respect of the Samson Street Apartment.

Argument on behalf of the Appellant

The Appellant argued that the disallowed amount was claimable on the basis of subsections 20( 1 ) and (3) of the Income Tax Act (the “Ac/”), and taking into consideration section 43 of the Family Relations Act, R.S. 1979,

c. 121 for the Province of British Columbia. This section of the Family Relations Act deals with the equality of entitlement to family assets on marriage breakup. There was no issue about this and the Court is satisfied that on the breakup of the marriage the Appellant and his spouse were entitled to one-half of the interest in the Samson Street property, on the basis of it being a family asset.

Counsel for the Appellant said that the case of Wilson v. Minister of National Revenue (1990), 90 D.T.C. 1744 (T.C.C.) was on all fours with the present case. He relied further on the comments with respect to deductibility as set out in Shell Canada Ltd. v. R., (1998), 98 D.T.C. 6177 (Fed. C.A.).

The only difference according to counsel for the Appellant was that in Wilson (supra) the husband had agreed to pay the interest to the wife rather than borrow it from a bank as in the case of Shell Canada Ltd. (supra). The Appellant’s spouse had a 50% interest in all of the assets of the Appellant including the Samson Street property as well as an interest in the Jura Street home (net gain $85,000.00), an interest in the Appellant’s boat and other assets as well. The Appellant wished to control the income earning property by himself so he entered into the agreement with his spouse and obtained sole ownership of that property.

When you look at all of the facts, the importance of the Samson Street property was the motivating factor which moved the Appellant to sign the agreement and to obtain a quit claim deed for the property. In essence the facts in the case at Bar are the same as the facts in Wilson (supra).

The substance of the transaction was the acquiring of the income earning asset, which was the interest of the Appellant’s spouse in the Samson Street property, even though there were property items transferred other than interest. Counsel also referred to a technical interpretation bulletin dated June 28, 1993 which essentially sets out that where there are funds borrowed and used in part to acquire an income producing asset and a nonincome producing asset, one may deduct a portion of the interest based on the portion of the debt. In this case, that is calculable and the Court should complete that function.

Counsel suggested that the other assets which the Appellant transferred to his spouse were very little in value but in any event were all set off by what she gave him back in the agreement. The only asset which would have been of significant value was a $42,500.00 interest in the Jura Road property.

In essence, the Appellant’s counsel asked the Court to allow the appeal with respect to the whole amount, but if not, then the Court should only disallow interest with respect to the $42,500.00.

In summary, in this case the money was borrowed for an allowable use because the direct line of the funds was to obtain the income earning property which was a one-half interest in the Samson Street property.

Counsel distinguished this case from that of Mark Resources Inc. v. R. (1993), 93 D.T.C. 1004 (T.C.C.) where the concern was for the whole substance of the operation which was aimed at the avoidance of taxation. That situation does not exist in the case at Bar.

Argument of the Respondent

Counsel for the Respondent distinguished the Wilson case, (supra) from the case at Bar in that Wilson (supra) was decided on the basis of subparagraph 20( 1 )(c)(ii) and not on the basis of (1), because in Wilson (supra) the money was not borrowed, whereas in the present case the money was borrowed.

In a normal situation, borrowing money in order to settle a matrimonial claim is a personal matter and is not deductible. She relied upon Bronfman Trust v. R. (1987), 87 D.T.C. 5059 (S.C.C.), in support of her position that there must be a current and direct use of the funds for an eligible purpose in order for them to be deductible. In the case at Bar, as can be seen from the settlement agreement, the $300,000.00 was paid for the relinquishment by the wife of any claim against any assets of the husband in which he had an interest and not just the income earning property. In Wilson (supra), most of the assets listed in the schedule in the agreement were those of a major income learning asset which was Taja Investments Limited. The expenditure in that case was more particularly related to the purchase of the income earning asset. Again, she said that the Appellant cannot succeed here because this case falls under the provision of (i) and not (ii) as decided in Wilson (supra).

In the case at Bar there is no specific evidence as to the value of the husband’s assets except the Samson Street property.

There was no cancelling out of equal amounts and therefore this was really the settlement of family matters and not a payment for the giving up of the spouse’s interest in an income earning asset.

However, if the Court accepts the argument that some of the interest was deductible, then the Appellant is not entitled to deduct all of the interest, but only a portion thereof and the value of the husband’s other assets, other than the income asset, should be deducted from the amount before the interest deduction is calculated.

Further, counsel argued that if the Appellant is entitled to deduct anything she is not sure what that amount should be. The burden is upon him and consequently, the Court should not order that he be entitled to deduct any of the amount as he has not met that burden.

Counsel argued that the appeal should be dismissed with respect to this contested item.

Rebuttal

Counsel argued that the interest payment is deductible under subparagraph 20( 1 )(c)(i) because that subparagraph refers to money borrowed for the purpose of earning income from a business or property and because he borrowed the money instead of paying it himself, that is no reason not to apply the result in Wilson (supra) because it is the purpose of the use of the money and not how the Appellant arranged to obtain the money that is important.

Counsel argued that in Wilson (supra), Taja Investments Limited owned the apartment block and other assets as well. In this case, Mr. Erskine gave clear evidence as to the value of the boat. With respect to the Samson Street property one must also consider the effect of capital gains as a liability. The Appellant had accounting advice and legal advice and consequently this must have been taken into account. That may in part explain why the amount of the settlement was not one-half of the appraised value of Samson Street, but somewhat less. The real value of the furnishings is set out in the Agreed Statement of Facts.

Counsel argued that in accordance with the decision in Shell Canada Ltd. (supra) one must step back and look at all of the facts. In the case at Bar the main asset was the Samson Street property. Therefore, the funds were borrowed for the purpose of gaining and producing income from that property and the deduction should be allowed in full.

Analysis and Decision

The Court is satisfied that in order for the Appellant to be successful in this appeal on the one remaining contested issue, it is necessary for him to bring himself within the provisions of subsection 20(1) of the Act. The only possible basis for claiming the interest deduction is subparagraph 20( 1 )(c)(i). That provision makes deductible, borrowed money used for the purposes 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). It is clear that the factual situation here cannot bring the Appellant within the provisions of subparagraph 20(1 )(c)(ii) as in Wilson (supra).

Counsel for the Respondent argued that Wilson (supra) gives no consolation to the Appellant’s position because it was decided on the basis of subparagraph 20( 1 )(c)(ii), and this is not the situation that the Appellant found himself in during the year in question. However, the Court is satisfied that even though Wilson (supra) was decided on the basis of that subparagraph, that does not mean that the case does not apply to the facts or situation in the case at Bar. Indeed, the factual situation in Wilson (supra) is remarkably similar to the factual situation in the case at Bar even to the point where the amount of money in issue was basically the same. That case involved the interpretation of a divorce settlement agreement and a legal obligation to pay interest which had been accepted by the taxpayer in order to acquire his spouse’s interest in his pension plan and in certain shares of his own corporation. The Court found that the interest paid was on “an amount payable for property acquired for the purpose of gaining or producing income therefrom” and allowed the deduction.

It is true that in that case, the income earning asset, Taja Investments Limited, owned the vast majority of all of the property listed in Schedule “A” which were the husband’s assets, including his pension plan, which was also an income earning asset. Schedule “B” which contained the wife’s assets listed a joint tenancy in the property in Vancouver, some jewellery and 250 shares in Rural Stores Limited and other assets.

Judge Christie found that the husband acquired his wife’s interest in the shares of Taja in the context of an agreement designed to settle their outstanding differences on a number of issues arising out of the breakdown of the marriage. The $300,000.00 was directly identifiable with securing his wife’s interest in the shares of Taja and the pension fund. The Appellant expressly acknowledged that his wife was entitled to an interest in the shares and the pension fund. His purpose in paying the interest and eventually the principle sum of $300,000.00 was to secure his wife’s interest in the shares of Taja and the pension for the purpose of gaining or producing income for himself therefrom. To that extent the facts can be distinguished from the facts in the case at Bar. The difference in facts as found in Shell Canada Ltd. v. R., (supra) that (ii) applies and not (1), does not mean that the findings in that case are not applicable to the case at Bar. On the contrary, the Court finds that the case is applicable and is indeed helpful.

As argued by counsel for the Appellant, it is not the process by which the money was obtained which is important but what the money was used for. The relevant statutory provision allows a deduction whether the money is borrowed from a lending institution or obtained by some other means. In the case at Bar the interest is no less deductible because it was expended to pay the interest on money borrowed rather than paying the interest to the spouse in accordance with the agreement.

The decision in Wilson (supra) is not at odds with the decisions in the cases referred to by the Appellant and cited above. The Court, in Bronfman Trust (supra), has acknowledged that recent tax jurisprudence has encouraged the moving away from a test based on a formal transaction and towards a test based on a “common sense appreciation of all of the guiding features of the event in question”. Therefore, the Supreme Court of Canada qualified the requirement that borrowed where money is used directly to earn income where there are exceptional circumstances and on a real appreciation of the taxpayer’s transaction, it might be appropriate to allow the taxpayer to deduct interest on funds borrowed for an ineligible use because of an indirect effect on the taxpayer’s income earning capacity and where it was his bona fide purpose in using the borrowed funds to earn income. Further, a finding to allow interest to be deducted in the circumstances as in Wilson (supra) or on the facts found in the case at Bar would not be contrary to the finding of Bowman J. in Mark Resources Inc. (supra). That decision can be distinguished from the present case because this Court is not concerned that the taxpayer in this case was attempting to do what Judge Bowman believed the taxpayer was attempting to do in that case.

In the case of Robitaille c. R. (1997), 97 D.T.C. 1286 (T.C.C.) , Judge Dussault in interpreting Bronfman Trust (supra) said “Secondly, for the purposes of the deduction provided for in paragraph 20(1)(c) of the Act, it has also been established in Bronfman Trust (supra) that what should be considered is not the purpose of the borrowing itself but rather the purpose for which the borrowed money was used.”

In the case at Bar, the Court has no doubt that at least some of the money that was borrowed meets those tests and that some of the interest paid should be deductible.

However, the second issue is of some importance and that is, how much of the interest should be capable of being deducted since there was clearly a use of some of the funds in the present case to obtain property which was not income producing and counsel for the Respondent’s position is well taken when she argues that point.

On the basis of the separation agreement entered into between the parties on the 15th day of March 1991, it is clear that the wife, in consideration for the $300,000.00, gave up an interest in not only the income earning asset which was the Samson Street property, but also an interest in the following articles: (1) a 1966 Volkswagen Sedan; (2) Furniture located at Jura Road; (3) a Santa Cruz Utility Trailer; (4) an Odette Utility Trailer; (5) a 1977 Nor-Sea Sailboat; (6) various REERs and investments registered in his name; (7) an interest in Peninsula Firewood Ltd. and certain bank accounts.

It is true, as counsel for the Appellant argued, that some of the items owned by the Appellant were traded off against certain items owned by his spouse. However, there was no clear evidence with respect to the valuation of a number of these articles nor was there any attempt in the separation agreement itself to value them. This was a shortcoming of the agreement and may be reflective of the fact that possibly the deductibility of the interest was not considered by the drafters of the separation agreement and only became significant after the agreement was put into place.

There can be no doubt from the agreement that what the Appellant was obtaining in return for the payment of $300,000.00 was obviously more than the right to obtain his spouse’s one-half interest in the income earning assets. To conclude otherwise is to completely ignore not only the separation agreement but the agreement as to facts which has been placed into evidence in this case.

The Court is satisfied that the Appellant cannot escape the results of the failure to provide an accurate valuation of all of the non-income earning assets and it is insufficient to argue that one was merely offset against an asset of the wife or that the items other than the Samson Street property had a value of little significance. In respect to some of the assets, the value was quite considerable and it would have been advisable for the Appellant to have established by evidence a reasonable value for all of these items or at least to have had an agreement with counsel for the Respondent as to their value.

On this basis, counsel for the Respondent argues that since the Appellant failed to meet his burden with respect to an accurate valuation of the nonincome producing assets that the Appellant should be shut out from claiming any of the interest expense. However, this Court finds that to do so would not be reasonable and indeed would be harsh and unfair.

There was some evidence before the Court with respect to the value of some of these assets and the Court finds as follows: (1) the 1977 Nor-Sea Sailboat was not an income producing asset and the interest payment in question relates partly to its acquisition.

A fair value of this item, in the absence of any more specific evidence as to a different value is the sum of $34,000.00, the Appellant’s interest being $17,000.00. The evidence was not clear on this point, but the Court finds that the barn located on the property at Jura Road, which the Appellant himself said was built for approximately $34,000.00, was included in the valuation of this property and the Court finds that the Appellant purchased an interest in that property of $42,500.00. This was not an income earning asset and part of the interest in issue relates to that acquisition.

The difference between the value of the personal furnishings at Jura Road belonging to the Appellant and those at Grosvenor Road belonging to his spouse was $42,037.00. Consequently, the Appellant was purchasing assets to a net value of $21,018.50. Some of the interest in question was obviously attributable to that purchase and this is not deductible.

The Court is satisfied that the 1966 Volkswagen Sedan had an antique value only and the Court will assign no value to it.

Likewise, the interest in Peninsula Firewood Ltd. is probably of little value and the Court assigns no value to it.

With respect to the Santa Cruz Utility Trailer, the Odette Utility Trailer, the various REERs and the investments registered in the Appellant’s name and the interest in certain bank accounts, the Court sets these off against the assets of the wife in which the Appellant released any claim, being the 1988 Subaru and certain bank accounts. The end result is that the Court finds that the Appellant did not expend any of the interest in question for purchase of those items.

Therefore, the appeal with respect to the disputed item, is allowed, and the matter is referred back to the Minister of National Revenue for reassessment and reconsideration on the basis that the Appellant is entitled to deduct a portion of the interest paid for the financial settlement under the separation agreement based upon the following formula: The total amount of borrowed funds used to purchase an income earning asset, $215,869.50, over the total amount borrowed, $296,488.00, multiplied by the interest paid by the Appellant on the amount of $259,758.20, in each of the years 1991 to 1995 inclusive.

Counsel for the Respondent pointed out that the wife’s settlement was somewhat less than one-half of the value of the Samson Street property according to the appraisal but the Court is satisfied that that does not affect the determination of the formula mentioned above because there may very well have been many reasons why she agreed to the figure that she did and that is not the subject matter of dispute.

The Appellant will have his costs of his action to be taxed.

Appeal allowed in part.