Phyllis Barbara Bronfman Trust v. Her Majesty the Queen, [1979] CTC 524, 79 DTC 5438

Marceau, J:—The plaintiff is a trust established in 1942 by one Samuel Bronfman in favor of his daughter. Pursuant to the deed of trust, the latter, as the institute, is entitled to receive annually 50% of the revenues from the trust property and may from time to time be assigned, at the discretion of the trustees, capital allocations of that property. In December 1969 and March 1970, two capital allocations in the amounts of $500,000 and $2,000,000 respectively were so made by the trustees to the institute. At the time, the assets of the trust, all of an income-earning nature, consisted of a portfolio of securities in public and private companies having a cost base in excess of $15,000,000 and a fair market value estimated at more than $70,000,000. It was felt by the trustees and their financial advisers, however, that the time was not appropriate for disposing of any of those securities, so, in order to give effect to the allocations, money was each time borrowed from a bank. The question that arises here is whether the plaintiff was entitled, as it claimed, to deduct from its earnings, for income tax purposes, the interests it paid to the bank ($110,114 in 1970, $9,802 in 1971 and $1,432 in 1972) until the loans were redeemed in 1972.

The legislative provisions here concerned are contained in paragraphs II (1 )(c) and 12(1 )(a) of the Income Tax Act, 1952 RSC, c 148, for the 1970 and 1971 taxation years and in paragraphs 18(1)(a) and 20(1)(c) of the new Act, 1970-71-72, SC, c 63 for the 1972 year. Pursuant to these provisions, interest on borrowed money is deductible if the money was “used for the purpose of earning income from a business or property”.

The plaintiff's contention is that even if the proceeds of the loans negotiated with the bank were actually used to pay the allocations made in favor of the institute, they must still be deemed to have been “used for the purpose of earning income from property” within the meaning of the Act, since there use allowed the trust to retain securities which were income producing and which moreover increased in value before the loans were redeemed. This contention, according to counsel, would be directly in line with the decision rendered by the Exchequer Court, in 1970, in the case of Trans-Prairie Pipelines Ltd v MNR, [1970] CTC 537; 70 DTC 6351. The defendant disagrees, and in view rightly so.

The Trans-Prairie Pipelines decision, as I understand it, cannot be taken as an authority for the submission advanced by the plaintiff and such a submission appears to me to be unacceptable in view of the language used by the legislator in the applicable sections of the Acts.

The facts in the Trans-Prairie Pipelines case and the decision of the then president of the court, Jackett, P, are summarized in the headnote as follows:

The appellant company was incorporated in 1954 to construct and operate a pipeline, its original issued capital being a number of common shares and 140,000 redeemable preferred shares, the latter having a total par value of $700,000. In 1956 the company issued $700,000 first mortgage bonds and used $400,000 of the amount so borrowed (with $300,000 obtained by issuing additional common shares) to redeem the preferred shares. In 1956 (and subsequent years) the company deducted the interest paid on its bonds; in 1956 it also deducted (under section 11(1)(cb) legal expenses incurred in connection with the bond issue and the preferred share redemption. The Minister allowed the company to deduct only three-sevenths of the claimed expenses. The Minister took the position that four- sevenths, or $400,000, of the money borrowed through the issue of bonds was used by the company to redeem its preferred shares and not used for the purpose of earning income from its business; that interest on the $400,000 was therefore not deductible under section 11(1)(c); and that legal expenses incurred in the course of borrowing only $300,000 of the $700,000 could be deducted under section 11(1)(cb). When the Appeal Board (65 DTC 642) agreed with the Minister’s interpretation, the company appealed to the Exchequer Court.

Held: The appeal was allowed. The appellant company was entitled to deduct all of the interest paid on its bonds during the years in question and all of the legal expenses claimed under section 11(1)(cb). The whole of the $700,000 borrowed on the bonds was, during those years, borrowed money used for the purpose of earning income from the company’s business was the $700,000 subscribed by the preferred shareholders and the amount subscribed by the original common shareholders. After those transactions, the money subscribed by the preferred shareholders had been withdrawn and what the company was using in its business to earn income was the amount subscribed by common shareholders (original and additional) and the $700,000 of borrowed money. As a practical matter of business common sense, the $700,000 of borrowed money went to fill the hole left by the redemption of the $700,000 preferred shares. Surely, what must have been intended by section 11(1)(c) was that the interest should be deductible for the years in which the borrowed money was employed in the business rather than that it should be deductible for the life of the loan as long as its first use was for the purpose of earning income from the business.

I see this decision as an application of the well-known principle laid down in tax cases whereby it is the actual and real effect of the transaction or the series of transactions in question that must be looked at rather than its or their legal or apparent aspect. The transactions entered into by the company in the Trans-Prairie case had the sole effect of replacing, as part of its capital, the money originally subscribed by the preferred shareholders by money borrowed through the issue of bonds. A mere change of creditors had thereby been effected, without any modification in the financial posi- tion of the company. Through a proper interpretation of the word “use”, as it appeared in subparagraph 11(1)(c)(i) of the Act then in force, the learned President avoided the unacceptable result according to which the taxing authority could benefit from transactions completed for that sole purpose.

The situation in the case at bar is quite different. The money was not borrowed here to redeem a debt previously incurred to acquire the income earning property of the trust. The series of transactions entered into by the trustees—ie the capital allocations, the borrowing of money, the payment to the institute, and by so doing the retaining of securities which otherwise would have been disposed of—did more than simply change the composition of the income earning property of the trust: that property was definitely reduced by some $2,500,000. While the decision in the Trans-Prairie case left the taxing authority in the same position as that in which it was prior to the agreement, the decision here sought by the plaintiff would mean that without doing anything that could enhance the value of its property, nor even anything that could change the composition of its assets, the trust could nevertheless render non-taxable part of its income.

Counsel for the plaintiff argued with force that the end result of the transactions was the same as if the trustees had sold assets to pay the allocations and then borrowed money to replace those assets, in which case the interest on the loans no doubt would have been deductible. But, I do not agree that the result would have been the same. If assets had been sold, these would have remained income producing and therefore tax producing, and the borrowed money would have been added to the total amount of income and tax producing capital; whereas here, no money was added to the tax producing capital. That is a difference which, to my mine, is decisive in view of the rationale that lies behind the rules laid down by Parliament with respect to the deductibility for income tax purposes of interest payable by a taxpayer on borrowed money.* [1]

In my view, it cannot be said that in the circumstances of this case the money borrowed from the bank of the plaintiff was “used to earn income from property” within the meaning of the former and present Income Tax Acts, and the Minister was right in disallowing deduction of the interest payable thereon.

The appeal will therefore be dismissed.