Date: 19980923
Docket: 96-4838-IT-G
BETWEEN:
LEWISPORTE HOLDINGS LIMITED,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for Judgment
Teskey, J.T.C.C.
[1] The Appellant appeals its reassessment of income tax for its 1985 taxation year.
Issue
[2] The sole issue is the deductibility of interest payments from income which payments were paid on a loan from the Bank of Nova Scotia.
Facts
[3] The corporate structures, because of name changes, are quite confusing, which I will attempt herein to clarify.
[4] The Appellant was originally incorporated in 1947 under the name Lewisporte Wholesalers Limited. It's name changed in 1985 to Lewisporte Holdings Limited.
[5] Horwood Lumber Company Limited was incorporated in 1902. On December 23, 1974, it changed its name to Del Holdings Limited and will be referred to as "OLDCO".
[6] In 1973, a company was incorporated using the name of Del Holdings Limited which changed its name to Horwood Lumber (1974) Limited on December 23, 1974, and will be referred to as "NEWCO".
[7] Noral Blair ("Blair") is the president of the Appellant and gave evidence at trial. I accept his testimony completely and without reservation.
[8] The Appellant had a substantial wholesale business based in Lewisporte, Newfoundland, together with related companies in Corner Brook and Bishop's Falls. This business covered the whole of Newfoundland, with the exception of the Avalon Peninsula.
[9] In August of 1973, Messrs. Duncan and Edward Sharpe (the "Sharpe Brothers") held an option to purchase all the shares of OLDCO.
[10] OLDCO had a lumber business on Water Street in St. John's.
[11] The Sharpe Brothers approached Blair in August of 1973 to see if the Appellant would join in the purchase of OLDCO's shares.
[12] The Appellant guaranteed bridge financing put up by the Bank of Nova Scotia (the "Bank") for the sum of $230,000 and became a 35% shareholder of NEWCO, which at the same time purchased all the shares of OLDCO. Part of the agreement was to the effect that if long term financing was not available to NEWCO without the Appellant's guarantee by November 30, 1973, then Lewisporte and Blair would become 50% shareholders of NEWCO.
[13] At the end of August 1973 when the transaction closed, NEWCO purchased all the shares of OLDCO. NEWCO's shareholding was 50,000 shares held by the Sharpe Brothers, 25,000 shares held by the Appellant which were pledged to the Bank, and 10,000 shares were held by Blair.
[14] In 1974, the Appellant received an additional number of shares of NEWCO, so that it and Blair then owned 50% of NEWCO.
[16] The Appellant guaranteed further loans with the Bank to a total amount of $350,000.
[17] In July of 1975, the Appellant increased its guarantee of the NEWCO operating loan to $300,000, thus raising its total guarantees to $475,000.
[18] The Bank, in addition to the Appellant's guarantees, required OLDCO to give a debenture security on all of OLDCO's real and immovable properties and its leasehold properties.
[19] The total guarantees by the Appellant to the Bank in 1977 remained at $475,000.
[20] On March 14, 1977, NEWCO and OLDCO gave debenture security to the Appellant for the principal amount of $2 million.
[21] The security debenture gave the Appellant security on several houses OLDCO was building, the lumber business and a retail site in downtown St. John's. At the time OLDCO was in financial trouble and owed the Appellant about $1,7 million.
[22] On December 10, 1977, the Appellant increased its guarantee to the Bank to $600,000 and acknowledged that its security against NEWCO was second to the Bank's interest.
[23] In 1977 and again in 1988, the Appellant waived interest owing to it by NEWCO, as NEWCO was experiencing financial difficulties.
[24] In 1979, the Appellant cut off credit to NEWCO.
[25] On March 27, 1980, the Board of Directors of the Appellant considered a proposal from P.M. Robinson and Associates Limited ("Robinson") for the development of OLDCO's property in downtown St. John's.
[26] The proposal called for the acquisition of properties on the perimeter of the lumber site as well as the retaining of architects and other design consultants.
[27] The proposal was accepted by the Appellant, partly because the preliminary estimated value of the OLDCO sites was $3,5 million. The Appellant accepted the proposed recommendation to purchase seven to ten key properties which would leave another 14 to 17 properties to be either purchased later or left out of the development.
[28] In 1980, Cabot Developers expressed interest in the Horwood property but ultimately and subsequently built a hotel (Delta) and an office building several blocks away from the OLDCO property on New Gower Street.
[29] The Robinson proposal was discussed at length with the Sharpe Brothers and agreements were entered into between Lewisporte with OLDCO and NEWCO.
[30] On April 1, 1980, Lewisporte, OLDCO and Blair entered into an agreement with Robinson. The agreement retained Robinson as the exclusive agent for acquisition and marketing of the properties. The Appellant and Blair agreed to put up sufficient funds to complete the purchase of the perimeter properties. Robinson proceeded, as required by the agreement, to seek all necessary approvals for the proposed comprehensive commercial development.
[31] Lewisporte advanced all the required funds from time to time for the purchase of the freehold title of perimeter properties. Title was taken into various incorporated shelf companies which the Appellant's solicitor, Ronald Noseworthy ("Noseworthy"), had available. Title was held by these shelf companies, as agent for NEWCO on Lewisporte's instructions.
[32] Six perimeter properties were acquired this way and title was placed in the names of: J.R. Collectibles Limited, City Service Centre Limited, West End Deli Limited and Galco Limited.
[33] Two further acquisitions were also placed in Galco Limited's name.
[34] The Appellant also provided $575,000 for the acquisition of the freehold of a portion of the OLDCO site that had previously been held as a leasehold.
[35] The development proposal called for four separate office towers, each of 12 storeys, containing approximately 15,000 sq. feet per floor, a 300-room hotel, an atrium with 80,000 square feet of retail shops and an enclosed parking garage (see Exhibit A-2). The estimated cost was approximately $130 million, it being believed that the land was worth $10 million. That is, if the proposed development was sold to a third party developer, it was anticipated the land assembled would bring a sale price of $10 million, or if the Appellant entered into a joint adventure with a developer that it would be credited $10 million for putting the land into the adventure.
[36] On April 1, 1981, the Appellant increased its guarantee by $2,6 million in respect of NEWCO to the Bank, thus guaranteeing a total of $3 million to the Bank.
[37] NEWCO's financial statement for the year-end December 31, 1980 showed liabilities to the Bank of $771,467 made up of a loan of $750,000 and a bank overdraft of $21,467. The notes thereto show that the Bank was secured by: (a) assignment of accounts receivable; (b) assignment of inventories; and (c) guarantee of Lewisporte of $600,000.
[38] Since the inventories were $858,759 and the receivables were $724,404, making a total of $1,6 million, there was more than sufficient security to satisfy the Bank.
[39] The financial statement for NEWCO for the year-end December 31, 1981 also demonstrates that there was sufficient inventory and receivables to more than satisfy any indebtedness to the Bank.
[40] The Appellant agreed to the large increase of its guarantee to the Bank ($600,000 to $3 million) in April of 1981 because of the agreement between the Appellant, NEWCO and OLDCO, as it would allow them to continue to promote the development which was ongoing.
[41] In January 1982, the Appellant paid architectural fees of $20,000 and disbursements of $3,538.16 for the design presentation.
[42] In March of 1982, the Bank crystallized its 1981 NEWCO floating debenture and the 1977 debenture NEWCO and OLDCO had given to the Appellant, who had hypothecated it to the Bank.
[43] NEWCO had a net loss of $798,019 in 1982 and a net loss of $318,365 in 1983.
[44] The Appellant paid $2,1 million to the Bank on April 28, 1983 pursuant to its obligation on the $3 million guarantee. The Appellant received in return the two debentures referred to in paragraph [42]. The honouring of the guarantee was part and parcel of the development proposal whereby the lumber business was to be phased out in an orderly fashion and the property to be the subject of large scale development with financing of acquisition of freeholds and perimeter properties, as well as related matters being carried out by the Appellant.
[45] In order for the Appellant to pay the $2,1 million to the Bank and proceed, it borrowed from the Bank $4,175 million on April 28, 1983.
[46] In 1985, the Appellant claimed an interest deduction as an expense respecting the funds used to pay off the guarantee for which the Appellant received the two debentures held by the Bank over the development properties. The payment to the Bank gave the Appellant complete control of all the assets of OLDCO and NEWCO. The only entity with any possible claim would be the Sharpe Brothers, who were for all practical purposes, out of the picture.
[47] In 1983, the Appellant received a written offer through a real estate agent by the name of Furlong of $3,2 million for the development properties. The offer was not accepted, being ridiculously low as the development of the properties was being actively pursued and the belief was that the value was in the neighbourhood of $10 million.
[48] In 1985, OLDCO, while not in the lumber business, was along with NEWCO, in the business of renting out the buildings located on the development proposal lands. OLDCO also held lands in Norwood and Gander that had to be managed. Both OLDCO and NEWCO are still in existence and hold title to a major development proposal believed to have a value in 1981 of some $10 million.
[49] The Appellant, by reason of the debentures it holds against NEWCO and OLDCO, has complete control over the development proposal lands. There is a direct connection between the money borrowed from the Bank and immediately paid back to the Bank to pay off the guarantee. These funds gave the Appellant complete control over all the lands owned by both OLDCO and NEWCO. The Appellant's directors and shareholders believed the development lands alone would have a value of $10 million when the proposed $130 million Petroleum Plaza was developed.
[50] The Appellant's borrowing from the Bank of $4,175 million on April 28, 1983 was for the sole purpose of gaining total and complete control over all the assets of OLDCO and NEWCO for the purpose of gaining or producing income from these assets.
The Law
[51] This appeal revolves around the application of paragraph 20(1)(c) of the Income Tax Act (the "Act"), the relevant parts of which read as follows in relation to this appeal:
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),
...
or a reasonable amount in respect thereof, whichever is the lesser;
[52] The definitive case on interest deductibility is the Supreme Court of Canada decision of The Queen v. Bronfman Trust, 87 DTC 5059. The Bronfman Trust borrowed $2.2 million and paid it to the trust beneficiary, Phyllis Barbara Bronfman. It sought to deduct interest on the borrowed $2.2 million, and argued that by borrowing it, it had preserved the capital of the trust. The Supreme Court of Canada held that the interest was not deductible. The $2.2 million had not been used for the purpose of earning income. Rather, it had been paid to Ms. Bronfman.
[53] Chief Justice Dickson said at page 5064, under the heading:
ELIGIBLE AND INELIGIBLE USES OF BORROWED MONEY
"It is perhaps otiose to note at the outset that in the absence of a provision such as s. 20(1)(c) specifically authorizing the deduction from income of interest payments in certain circumstances, no such deductions could generally be taken by the taxpayer. Interest expenses on loans to augment fixed assets or working capital would fall within the prohibition against the deduction of a "payment on account of capital" under s. 18(1)(b): Canada Safeway Ltd. v. M.N.R., [1957] S.C.R. 717, [57 DTC 1239], at pp. 722-23 per Kerwin C.J. and at p. 727 per Rand J.
I agree with Marceau J. as to the purpose of the interest deduction provision. Parliament created s. 20(1)(c)(i), and made it operate notwithstanding s. 18(1)(b), in order to encourage the accumulation of capital which would produce taxable income. Not all borrowing expenses are deductible. Interest on borrowed money used to produce tax-exempt income is not deductible. Interest on borrowed money used to buy life insurance policies is not deductible. Interest on borrowings used for non-income earning purposes, such as personal consumption or the making of capital gains is similarly not deductible. The statutory deduction thus requires a characterization of the use of borrowed money as between the eligible use of earning non-exempt income from a business or property and a variety of possible ineligible uses. The onus is on the taxpayer to trace the borrowed funds to an identifiable use which triggers the deduction. Therefore, if the taxpayer commingles funds used for a variety of purposes only some of which are eligible he or she may be unable to claim the deduction: see, for example, Mills v. M.N.R., 85 DTC 632 (T.C.C.), No. 616 v. M.N.R., 59 DTC 247 (T.A.B.)
The interest deduction provision requires not only a characterization of the use of borrowed funds, but also a characterization of "purpose". Eligibility for the deduction is contingent on the use of borrowed money for the purpose of earning income. It is well established in the jurisprudence, however, that it is not the purpose of the borrowing itself which is relevant. What is relevant, rather, is the taxpayer's purpose in using the borrowed money in a particular manner: Auld v. M.N.R., 62 DTC 27(T.A.B.). Consequently, the focus of the inquiry must be centered on the use to which the taxpayer put the borrowed funds.
In my opinion, the distinction between eligible and ineligible uses of borrowed funds applies just as much to taxpayers who are corporations or trusts as it does to taxpayers who are natural persons. While it is true that corporations or trusts are less likely to be motivated by personal consumption purposes, there remains nevertheless a variety of ineligible uses for borrowed money which apply to artificial persons. A trust may, for example, purchase assets for the purpose of capital gain. Or, as in the present instance, it may distribute capital to a trust beneficiary. It follows, with respect, that I cannot accept the suggestion of the majority of the Federal Court of Appeal that virtually any use of borrowed funds by a trust, rather than by an individual, will satisfy the requirements of the statutory interest deduction. Fairness 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."
[54] Again, at page 5067, he said:
"... The taxpayer, of course, has a right to spend money in ways which cannot reasonably be expected to generate taxable income but if the taxpayer chooses to do so, he or she cannot expect any advantageous treatment by the tax assessor. In my view, the text of the Act requires tracing the use of borrowed funds to a specific eligible use, its obviously restricted purpose being the encouragement of taxpayers to augment their income-producing potential. This, in my view, precludes the allowance of a deduction for interest paid on borrowed funds which indirectly preserve income-earning property but which are not directly "used for the purpose of earning income from. . . property".
Even if there are exceptional circumstances in which, on a real appreciation of a taxpayer's transactions, 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, I am satisfied that those circumstances are not presented in the case before us. It seems to me that, at the very least, the taxpayer must satisfy the Court that his or her bona fide purpose in using the funds was to earn income. In contrast to what appears to be the case in Trans-Prairie, the facts in the present case fall far short of such a showing. Indeed, it is of more than passing interest that the assets which were preserved for a brief period of time yielded a return which grossly fell short of the interest costs on the borrowed money. In 1970, the interest costs on the $2,200,000 of loans amounted to over $110,000 while the return from an average $2,200,000 of Trust assets (the amount of capital "preserved") was less than $10,000. The taxpayer cannot point to any reasonable expectation that the income yield from the Trust's investment portfolio as a whole, or indeed from any single asset, would exceed the interest payable on a like amount of debt. The fact that the loan may have prevented capital losses cannot assist the taxpayer in obtaining a deduction from income, which is limited to use of borrowed money for the purpose of earning income."
[55] Chief Justice Dickson also confirms at page 5067-5068, that:
"... the courts must deal with what the taxpayer actually did, and not what he might have done ..."
[56] He also directs at page 5068 to characterize the taxpayer's transactions according to their true commercial and practical nature.
[57] The Federal Court of Appeal dealt with borrowed money to pay off a guarantee in 74712 Alberta Limited. v. the Queen, 97 DTC 5126. At issue was the deductibility of interest on a $1,7 million loan used by 74712 to discharge its guarantee of the indebtedness of its parent corporation Trennd Investments (1979) Ltd. to the Canadian Imperial Bank of Commerce (CIBC). The Appellant was one of a group of corporations largely owned by John Corbett Anderson of which Trennd Investments became the parent after a restructuring in 1979. In 1980, following the restructuring, the financial arrangements of the various sister corporations were consolidated into a credit facility which required cross guarantees by members of the Trennd Investments organization, including the Appellant. In 1981, CIBC called on its guarantees and the Appellant borrowed $1,7 million in order to satisfy its guarantee of its parent's liabilities.
[58] In dismissing the taxpayer's appeal Mr. Justice Linden refused to accept the Appellant's submissions that the reason the guarantee was given in the first place could be traced to an eligible income earning purpose. At page 5129 of the decision he states:
"In my view, the appellant has failed to convince this Court that the Trial Judge erred in denying the deduction either because the preservation of income-producing assets was the true purpose of the loan or because its true purpose could be traced back to the reason for which the guaranty was originally given. The Trial Judge was correct in concluding that the loan of $1.7 million was taken in order to honour the guaranty of the appellant and was not taken or used directly for the purpose of earning income from business or property."
Analysis
[59] I do not believe that the 74712 Alberta decision is applicable to this case as therein I had found that the borrowed money was not taken or used directly for the purpose of earning income.
[60] Herein, the purpose of the $2,1 million was to take complete control and in essence sole ownership of OLDCO and NEWCO, both companies having income-producing assets believed to have a value far in excess of the $2.1 million. By doing the transaction this way rather than request the Bank to sell the assets, they shut out all outside consortiums from bidding on the assets and the possibilities of denying the Appellant from what was its perceived income-producing stream.
[61] Since I accept the testimony of Blair and Furlong, and since OLDCO and NEWCO were still in business in 1985, what the Respondent's appraiser now considers what the properties were worth is immaterial. The Appellant believed the value of the properties was there and based on that, made business decisions that ought not be second guessed. Blair and his Board of Directors at Lewisporte believed that the Hibernia Oil Exploration and the development thereof would create a boom to St. John's and that there would be exceptionally large profits to be made from this project. The Appellant invested its own money and that of the banks on this belief which was "not" based on a fanciful whim.
[62] The whole purpose of the loan was to further the development project by obtaining control of OLDCO and NEWCO, which gave control over all the properties and a release of the Bank's claim at the same time.
[63] The appeal is allowed, with costs, and the assessment is referred back to the Minister of National Revenue for reconsideration and reassessment on the basis that in 1985, the appellant is entitled to deduct from income the interest expense on the loan with the Bank of Nova Scotia.
[64] The Appellant asks for an award of solicitor and his own client costs. From my reading of the authorities on this point, I am satisfied that such an award would not be appropriate. However, the costs incurred by the Appellant should be generous as the number of documents before the Court was quite numerous and written argument was requested by myself, which substantially increased the Appellant's costs.
Signed at Ottawa, Canada, this 23rd day of September, 1998.
"Gordon Teskey"
J.T.C.C.