The Queen v. Bronfman, [1987] 1 S.C.R. 32

Her Majesty The Queen Appellant

v.

Phyllis Barbara Bronfman Trust Respondent

indexed as: bronfman trust v. the queen

File No.: 17811.

1986: April 29; 1987: January 29.

Present: Dickson C.J. and Beetz, McIntyre, Chouinard*, Lamer, Wilson and La Forest JJ.

on appeal from the federal court of appeal

*Chouinard J. took no part in the judgment.

Income Tax ‑‑ Calculation of income ‑‑ Deductions ‑‑ Interest deduction ‑‑ Trusts ‑‑ Trust making allocation to beneficiary ‑‑ Money borrowed to prevent sale of assets ‑‑ Whether or not trust entitled to claim interest deduction ‑‑ Income Tax Act, R.S.C. 1952, c. 148, ss. 12(1)(a), 11(1)(c)(i) re‑en. S.C. 1970‑71‑72, c. 63, ss. 18(1)(a), 20(1)(c)(i).

The trustees of respondent trust elected to make discretionary capital allocations to its beneficiary in 1969 and 1970. Instead of liquidating capital assets to make the allocations, the trustees considered it advantageous to retain the Trust investments temporarily and finance the allocations by borrowing funds from a bank. The Trust deducted the interest on the borrowed money, an amount grossly in excess of the amount saved by not selling assets to meet the requirements of the allocation. The Tax Review Board and the Federal Court, Trial Division, on appeal by way of trial de novo, upheld the Minister's decision to disallow the deductions. The Federal Court of Appeal allowed an appeal from that judgment. At issue here was whether an interest deduction is only available where the loan is used directly to produce income or whether the deduction is 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 was whether the answer to this question depended on the status of the taxpayer as a corporation, a trust, or a natural person.

Held: The appeal should be allowed.

The statutory deduction 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. The interest deduction provision also provides for a characterization of "purpose" of the borrowed funds: the borrowed money must be used to earn income. The taxpayer's purpose in using the borrowed money in a particular manner is what is relevant. 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.

The current use rather than the original use of borrowed funds by the taxpayer is relevant in assessing deductibility of interest payments. The use of the borrowing here was not of an income‑earning nature.

Notwithstanding the movement away from strict construction of taxation statutes and towards determining the true commercial and practical nature of the taxpayer's transactions, a deduction, such as the interest deduction in s. 20(1)(c)(i) which by its text is made available in limited circumstances, has not suddenly lost all strictures. Although it can be characterized as indirectly preserving income, borrowing money for an ineligible direct purpose ought not to entitle a taxpayer to deduct interest payments. 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 precludes allowing 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 were exceptional circumstances in which, on a real appreciation of a taxpayer's transactions, it might be appropriate to allow the deduction of interest on funds borrowed for an ineligible use, those circumstances were not present here. The taxpayer, at the very least, must satisfy the court that its bona fide purpose in using the funds was to earn income. It is of more than passing interest that the assets preserved for a brief period of time yielded a return which grossly fell short of the interest costs on the borrowed money. The fact that the loan may have prevented capital losses cannot assist a taxpayer in obtaining a deduction from income which is limited to use of borrowed money for the purpose of earning income.

Cases Cited

Distinguished: Trans‑Prairie Pipelines Ltd. v. Minister of National Revenue, 70 D.T.C. 6351; considered: Sternthal v. The Queen, 74 D.T.C. 6646; referred to: Canada Safeway Ltd. v. Minister of National Revenue, [1957] S.C.R. 717; Mills v. Minister of National Revenue, 85 D.T.C. 632; No. 616 v. Minister of National Revenue, 2005 TCC 90, 59 D.T.C. 247; Auld v. Minister of National Revenue, 62 D.T.C. 27; Lakeview Gardens Corp. v. Minister of National Revenue, [1973] C.T.C. 586; Sinha v. Minister of National Revenue, [1981] C.T.C. 2599; Attaie v. Minister of National Revenue, 85 D.T.C. 613; Interior Breweries Ltd. v. Minister of National Revenue, 55 D.T.C. 1090; Garneau Marine Co. v. Minister of National Revenue, 82 D.T.C. 1171; Toolsie v. The Queen, [1986] 1 C.T.C. 216; Jordanov v. Minister of National Revenue, 86 D.T.C. 1136; Day v. Minister of National Revenue, 84 D.T.C. 1184; Eelkema v. Minister of National Revenue, 83 D.T.C. 253; Zanyk v. Minister of National Revenue, 81 D.T.C. 48; Holmann v. Minister of National Revenue, 79 D.T.C. 594; Huber v. Minister of National Revenue, 79 D.T.C. 936; Dorman v. Minister of National Revenue, 77 D.T.C. 251; Verhoeven v. Minister of National Revenue, 75 D.T.C. 230; Shields v. Minister of National Revenue, 68 D.T.C. 668; Cutten v. Minister of National Revenue, 56 D.T.C. 454; No. 228 v. Minister of National Revenue, 55 D.T.C. 39; No. 185 v. Minister of National Revenue, 54 D.T.C. 395; Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536; The Queen v. Golden, [1986] 1 S.C.R. 209; B.P. Australia Ltd. v. Commissioner of Taxation of Australia, [1966] A.C. 224; F. H. Jones Tobacco Sales Co., [1973] F.C. 825, [1973] C.T.C. 784; Hallstroms Pty. Ltd. v. Federal Commissioner of Taxation (1946), 8 A.T.D. 190; Cochrane Estate v. Minister of National Revenue, 76 D.T.C. 1154; Matheson v. The Queen, 74 D.T.C. 6176; Zwaig v. Minister of National Revenue, [1974] C.T.C. 2172.

Statutes and Regulations Cited

Income Tax Act, R.S.C. 1952, c. 148, ss. 12(1)(a), 11(1)(c)(i), 11(3)(b) re‑en. S.C. 1970‑71‑72, c. 63, ss. 18(1)(a), (b), 20(1)(c)(i), (3).

APPEAL from a judgment of the Federal Court of Appeal, [1983] 2 F.C. 797, 83 D.T.C. 5243, [1983] C.T.C. 253, allowing an appeal from a judgment of Marceau J., [1980] 2 F.C. 453, 79 D.T.C. 5438, [1979] C.T.C. 524, (disallowing a claimed deduction) on appeal by way of trial de novo from a judgment of Mr. Guy Tremblay of the Tax Review Board, 78 D.T.C. 1752, [1978] C.T.C. 3088, dismissing an appeal from the Minister's decision to disallow a claimed deduction. Appeal allowed.

Roger Roy, for the appellant.

Michael Vineberg, for the respondent.

The judgment of the Court was delivered by

1. The Chief Justice‑‑In computing income for a taxation year, a taxpayer may deduct interest paid on borrowed money "used for the purpose of earning income from a business or property". In the present appeal, the trustees of a Trust elected to make discretionary capital allocations to Phyllis Barbara Bronfman in 1969 and 1970. Instead of liquidating capital assets to make the allocations, the trustees considered it advantageous to retain the Trust investments temporarily and finance the allocations by borrowing funds from a bank.

2. 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.

I

Facts

3. By means of a Deed of Donation registered in Montreal on May 7, 1942 a Trust was established by the late Samuel Bronfman in favour of his daughter, Phyllis Barbara Bronfman ("the beneficiary" or, under Quebec law, "the Institute") and her children. Under the terms of the Deed, the beneficiary has the right to receive fifty percent of the revenue from the trust property. In addition, the trustees "in their sole and unrestricted discretion" are empowered to make an allocation to the beneficiary from the capital of the Trust if they consider it "desirable for any purpose of any nature whatsoever". The beneficiary has no children and in the event she dies without issue, the residue of the Trust accrues for the benefit of her brothers and sisters.

4. The assets of the Trust consist of a portfolio of securities having a cost base of more than $15,000,000. By the end of 1969 Trust assets had a market value of about $70,000,000. Except for a Rodin sculpture, the holdings of the Trust during the material period were in bonds and shares, assets which could be characterized generally as of an income‑earning nature. I should add, however, that the investment portfolio of the Trust produced a low yield: 1969, 1970 and 1971 earnings amounted to $324,469, $293,178 and $213,588 respectively, providing a return of less than one‑half of one percent on the portfolio's market value. Some of the Trust investments, although possibly bearing income in the long run, did not in fact earn any income over the material period. The financial statements of the Trust disclose, for example, that the Trust's investment in 2nd Preferred Shares of Cemp Investments Ltd. (a private, family corporation) which had a cost base of $3,300,000 yielded no income at all in 1969, 1970 and 1971. Trust investment policies appear to have been focused more on capital gains than on income. Accordingly, the Trust's very substantial asset base generated modest income tax liabilities: the 1970 and 1971 income tax returns filed by the taxpayer show federal tax payable of $12,107.99 and $15,687.98 respectively and in 1972 (when some capital gains were realized and, for the first time, taxable) federal tax was listed as $31,878.

5. The low‑yield investment portfolio of the Trust undoubtedly had detrimental consequences for the beneficiary in respect of the amount of income available under her fifty percent entitlement. Perhaps to mitigate those consequences, or perhaps for some other reason entirely, the trustees chose to make a capital allocation to the beneficiary of US $500,000 on December 29, 1969 and one of CAN $2,000,000 on March 4, 1970. There is no suggestion by the Trust that these allocations were in any way designed to enhance the income‑earning potential of the Trust. On the contrary, the inevitable result was to reduce the Trust's net income‑earning prospects both in the short‑term and in the long run owing to the depletion of Trust capital.

6. To make the capital allocations, the Trust borrowed from the Bank of Montreal US $300,000 on December 29, 1969 and CAN $1,900,000 on March 9, 1970. The amounts borrowed went into the account of the Trust and were used to make the capital allocations to the beneficiary. The Trust used uninvested earnings to finance the remaining approximately $300,000 of allocations to the beneficiary. There is no dispute concerning the immediate and direct use to which the borrowed funds were put. They were used to make the capital allocations to the beneficiary and not to buy income‑earning properties.

7. The sole witness at trial was Mr. Arnold Ludwick, an accountant, Executive Vice‑President of Cemp Investments and Executive Vice‑President of Claridge Investments. Claridge Investments managed the business affairs of the taxpayer Trust, subject of course to the ultimate authority of the trustees. Mr. Ludwick's evidence concerned the reasons for the borrowing. He testified that subject to various constraints on the marketability of some of the Trust investments, "it certainly would have been possible to, in an orderly way, liquidate investments" to fund the capital allocation. The funds were borrowed because such a disposition of assets would have been commercially inadvisable. As testified by Mr. Ludwick:

... my reasoning that existed then [in 1969] still exists today, that precise timing of the sale of investments ought to be related to the nature of the investment, and not a possible immediate need for cash on any particular day, that the basic issue [is one] of managing the assets side separately from the liability and capital side.

In addition, most of the investments at the time were not readily realizable, in part because of securities law constraints and in part because the marketable securities that the Trust did hold had dropped in value. Accordingly, the Trustees considered it inappropriate to sell them at that point; it appeared to be more advantageous for the Trust to keep the assets and borrow from the bank.

8. The evidence is unclear as to the precise amounts and dates of the loan repayments, but it is clear that the entire borrowings were repaid by 1972. In 1970 the Trust realized $1,966,284 and in 1972, $1,026,198, from the sale of shares of Gulf Oil Canada Ltd. Some of the proceeds from these dispositions were used to repay the bank loans. Thus the loans postponed but did not obviate the need for an eventual reduction in the Trust's capital assets. In the meantime, interest payments of $110,114 in 1970, $9,802 in 1971, and $1,432 in 1972 were incurred on the debts to the Bank of Montreal. It is the deduction of these interest payments from the Trust's income which is contested in this appeal.

9. The Trust argues that even if the loans were used to pay the allocations, they were also used for the purpose of earning income from property since they permitted the Trust to retain income‑producing investments until the time was ripe to dispose of them. The end result of the transactions, the Trust submits, was the same as if the trustees had sold assets to pay the allocations and then borrowed money to replace them, in which case, it is argued, the interest would have been deductible. The Crown, on the other hand, takes the position that the borrowed funds were used to pay the allocations to the beneficiary, that the amounts of interest claimed as deductions are not interest on borrowed money used for the purpose of earning income from a business or property and as such are not deductible.

II

Legislation

10. For the taxation years 1970 and 1971 the relevant legislation is s. 12(1)(a) and s. 11(1)(c)(i) of the Income Tax Act, R.S.C. 1952, c. 148. The sections read as follows:

11. (1) In computing income, no deduction shall be made in respect of

(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from property or a business of the taxpayer.

11. (1) Notwithstanding paragraphs (a), (b) and (h) of subsection 1 of section 12, the following amounts may be deducted in computing the income of a taxpayer for a taxation year:

(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 an interest in a life insurance policy) ...

11. These provisions were re‑enacted in S.C. 1970‑71‑72, c. 63. Sections 18(1)(a) and 20(1)(c)(i), applicable for the 1972 taxation year, read:

12. (1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property;

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) ...

12. Counsel have not suggested that the slight change in wording in s. 20(1) has any bearing on the issues raised in this appeal.

III

Judgments

(a) Tax Review Board

13. Mr. Guy Tremblay began his reasons for judgment by noting that the burden was on the Trust to show that the assessments were incorrect. He added:

This burden of proof derives not from one particular section of the Income Tax Act, but from a number of judicial decisions, including the judgment delivered by the Supreme Court of Canada in Johnston v. Minister of National Revenue, 3 DTC 1182, (1948) C.T.C. 195.

Mr. Tremblay reviewed the jurisprudence, in particular the main case upon which the Trust based its contention, Trans‑Prairie Pipelines Ltd. v. Minister of National Revenue, 70 D.T.C. 6351, a decision of Jackett P. in the Exchequer Court. In that case the taxpayer corporation wanted to raise capital by way of bond issues for expansion of its business. It discovered, however, that it was impossible, practically speaking, to float a bond issue unless it first redeemed its preferred shares, because of the sinking fund requirements of its preferred share issue. Accordingly, the taxpayer borrowed $700,000, used $400,000 to redeem the preferred shares and the remaining $300,000 for expansion of its business. Jackett P. held the interest payments on the entire $700,000 loan deductible. He saw the borrowed funds as "fill[ing] the hole left by the redemption". He stated, at p. 6354:

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 capital 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 in the business.

The main case on which the Crown relied to rebut the Trans‑Prairie case was Sternthal v. The Queen, 74 D.T.C. 6646 (F.C.T.D.) In Sternthal, a taxpayer with a large excess of assets over liabilities borrowed a sum of $246,800. On the same day he gave interest free loans to his children totalling $280,000. The taxpayer argued that he was entitled to use his assets to make loans to his children and to borrow for the purpose of "filling the gap" left by the making of such loans. Therefore, he argued, as long as the assets which made the loan possible were used to produce income, interest on the borrowing was deductible. Kerr J. did not agree. He held that the taxpayer used the borrowed money to make non‑interest bearing loans to his children, not for the purpose of earning income. The taxpayer chose to find the money for the loans by borrowing and the fundamental purpose of the borrowing was to make the loans.

14. Mr. Tremblay, in the present case, was of the opinion that the facts before him were more similar to Sternthal than Trans‑Prairie. He concurred in the reasoning of Kerr J. in Sternthal and concluded that he ought to look at what the interest expense was calculated to effect, from a practical and business point of view, in assessing whether it was "used for the purpose of earning income from a business or property." In attempting to apply such a test to the facts, Mr. Tremblay was not satisfied that the evidence was clear concerning the manner in which the Trust's income was augmented by the incurring of the loan expense. In his view, the trustees' policy of separating asset management from liability management might have been "a good administrative explanation". It was, however, "not sufficient to base a policy to allow deduction on interest paid on all loans made by the Trust for paying capital allocation[s] to the beneficiary". The evidence given was not complete. Accordingly the appeal was dismissed.

(b) Federal Court, Trial Division

15. The Trust took its suit to the Federal Court, Trial Division where it was heard de novo by Marceau J. ([1980] 2 F.C. 453). The Trust maintained its contention that even if the proceeds of the loans negotiated with the Bank were actually used to pay the allocations made in favour of the beneficiary, they must still be deemed to have been "used for the purpose of earning income from property" within the meaning of the Act, since their use allowed the Trust to retain securities which were income producing and which moreover increased in value before the loans were redeemed. Marceau J. said at p. 454, "The defendant [i.e., the Crown] disagrees, and in my view rightly so." More detailed evidence was produced regarding the assets held by the Trust. Nevertheless, Marceau J. dismissed the appeal. He, like Mr. Tremblay of the Tax Review Board, accepted the principle that it is the actual and real effect of a transaction or series of transactions that was relevant, rather than its "legal" or apparent aspect. If the transactions in the present case had merely changed the composition of the income‑earning property of the Trust by liquidating one debt and substituting another, then he would have accepted the proposition that the real purpose of the transactions was to earn income from the Trust. He concluded, however, that the net effect of the trustees' actions was to reduce the income‑earning property of the Trust by some $2,500,000. Marceau J. pointed out that at p. 456:

... 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.

In the opinion of the trial judge the interest deduction was designed to encourage accretions to the total amount of tax‑producing capital. Nothing was added to the capital base by the transactions of the Trust. It followed that the Minister was right in disallowing the deductions.

16. In summary, it appears that the critical factor for Marceau J. was that the borrowed money was used, directly or indirectly, to fund a reduction in the taxpayer's capital.

(c) Federal Court of Appeal

17. In the Federal Court of Appeal, [1983] 2 F.C. 797, Thurlow C.J., Hyde D.J. concurring, allowed the Trust's appeal. Thurlow C.J. held that the use of the borrowed money to pay the capital allocations was what enabled the trustees to keep the income‑yielding Trust investments and to exploit them by obtaining for the Trust the income they were earning. Thurlow C.J. said at pp. 800‑01:

Had the trustees sold income yielding investments to pay the allocations, the income of the trust would have been reduced accordingly. Had they given the beneficiary income‑yielding investments in lieu of cash, the income of the trust would have been reduced accordingly. By not doing either, by borrowing money and using it to pay the allocations, the trustees preserved intact the income‑yielding capacity of the trust's investments. That, as it seems to me, is sufficient, in the circumstances of this case, to characterize the borrowed money as having been used in the taxation years in question for the purpose of earning income from the trust property.

(Emphasis added.)

With respect, I have some difficulty with this passage. In a narrow sense it might be said that the trustees preserved intact the income‑yielding capacity of the Trust's investments but the practical and business reality of the situation was that the net income‑yielding capacity of the Trust was reduced by the annual debt load from the bank borrowings which, as I have said, amounted to $110,114 in 1970. Thurlow C.J., however, characterized the borrowed money as having been used for the purpose of earning income from property and it made no difference, according to him, that the immediate use of the funds was to pay directly the capital allocations rather than to repurchase investments which might have been liquidated to pay the allocations. In his view, the focus of the statute was on the income‑earning purpose of the trustees in continuing to hold the Trust investments. Moreover, it did not matter that the trustees, in continuing to hold the investments, might also have had an eye to the possible appreciation of their capital value. The majority of the Court did, however, express one important reservation on the scope of its holding. The majority, at pp. 801‑02, was careful to limit the ratio of its decision to trusts, as distinct from individuals:

It should be noted that a trust such as that here in question has no purpose and the trustees have no purpose save to hold trust property, to earn income therefrom and to deal with such income and the capital of the trust in accordance with the provisions of the trust instrument. In that respect a trust differs from an individual person who may have many purposes, both business and personal. Compare Sternthal v. Her Majesty The Queen ((1974), 74 DTC 6646 (F.C.T.D.)) where the taxpayer, an individual, had no obligation to lend money to his children but invested his borrowings in interest‑free loans to them.

18. Pratte J. dissented. He agreed with Marceau J. that the borrowed funds were in fact used to pay capital allocations in favour of the beneficiary. The allocations could not, by any stretch of the imagination, be considered as having been used for the purpose of earning income. In his view, Trans‑Prairie was not applicable. Unlike Trans‑Prairie, where the money previously subscribed by preferred shareholders had been used by the company for the purpose of earning income from the business, in this case the money paid to the beneficiary had not already been used by the trust for the purpose of earning income. Pratte J. said at p. 804:

Pursuant to the relevant provisions of the Income Tax Act, the interest here in question was not deductible unless the money borrowed from the Bank of Montreal had been "used for the purpose of earning income from a business or property". It was not so used but was, in fact, used to pay the capital allocations made by the Trustees in favour of Miss Bronfman. The appellant's argument, in my view, ignores the language of the Act.

With respect, I agree.

IV

Eligible and Ineligible Uses of Borrowed Money

19. 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. Minister of National Revenue, [1957] S.C.R. 717, at pp. 722‑23 per Kerwin C.J. and at p. 727 per Rand J.

20. 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. Minister of National Revenue, 85 D.T.C. 632 (T.C.C.); No. 616 v. Minister of National Revenue, 2005 TCC 90, 59 D.T.C. 247 (T.A.B.)

21. 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. Minister of National Revenue, 62 D.T.C. 27 (T.A.B.) Consequently, the focus of the inquiry must be centered on the use to which the taxpayer put the borrowed funds.

22. 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.

V

Original or Current Use of Borrowed Money

23. 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.

24. 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. Minister of National Revenue, [1981] C.T.C. 2599 (T.R.B.); Attaie v. Minister of National Revenue, 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.

25. There is, however, an important natural limitation on this principle. The borrowed funds must still be in the hands of the taxpayer, as traced through the proceeds of disposition of the preceding ineligible use, if the taxpayer is to claim the deduction on the basis of a current eligible use. Where the taxpayer has expended the borrowings on an ineligible use, and has received no enduring benefit or saleable property in return, the borrowed money can obviously not be available to the taxpayer for a subsequent use, whether eligible or ineligible. A continuing obligation to make interest payments to the creditor therefore does not conclusively demonstrate that the borrowed money has a continuing use for the taxpayer.

26. In the present case the borrowed money was originally used to make capital allocations to the beneficiary for which the Trust received no property or consideration of any kind. That use of the borrowings was indisputably not of an income‑earning nature. Accordingly, unless the direct use of the money ought to be overlooked in favour of an alleged indirect income‑earning use, the Trust cannot be permitted to deduct the interest payments in issue in this appeal.

VI

Direct and Indirect Uses of Borrowed Money

27. As I have indicated, the respondent Trust submits that the borrowed funds permitted the Trust to retain income‑earning properties which it otherwise would have sold in order to make the capital allocations to the beneficiary. Such a use of borrowings, it argues, is sufficient in law to entitle it to the interest deduction. In short, the Court is asked to characterize the transaction on the basis of a purported indirect use of borrowed money to earn income rather than on the basis of a direct use of funds that was counter‑productive to the Trust's income‑earning capacity.

28. In my view, neither the Income Tax Act nor the weight of judicial authority permits the courts to ignore the direct use to which a taxpayer puts borrowed money. One need only contemplate the consequences of the interpretation sought by the Trust in order to reach the conclusion that it cannot have been intended by Parliament. In order for the Trust to succeed, s. 20(1)(c)(i) would have to be interpreted so that a deduction would be permitted for borrowings by any taxpayer who owned income‑producing assets. Such a taxpayer could, on this view, apply the proceeds of a loan to purchase a life insurance policy, to take a vacation, to buy speculative properties, or to engage in any other non‑income‑earning or ineligible activity. Nevertheless, the interest would be deductible. A less wealthy taxpayer, with no income‑earning assets, would not be able to deduct interest payments on loans used in the identical fashion. Such an interpretation would be unfair as between taxpayers and would make a mockery of the statutory requirement that, for interest payments to be deductible, borrowed money must be used for circumscribed income‑earning purposes.

29. One finds in the Act not only the distinction within s. 20(1)(c)(i) between eligible and ineligible uses of funds, but other provisions which also require the tracing of funds to particular uses in a manner inconsistent with the argument of the Trust. Section 20(3) (formerly s. 11(3b)) stipulates, for example, that interest on money borrowed to repay an existing loan shall be deemed to have been used for the purpose for which the previous borrowings were used. This provision would, of course, be unnecessary if interest on borrowed money were deductible when the taxpayer had income‑earning properties to preserve. On the contrary, however, for taxation years prior to the enactment of s. 11(3b) in S.C. 1953‑54, c. 57, s. 2(6), it had been held that such interest was not deductible since the borrowings were used to repay a loan and not to earn income: Interior Breweries Ltd. v. Minister of National Revenue, 55 D.T.C. 1090, at p. 1093 (Ex. Ct.)

30. It is not surprising, therefore, that the cases interpreting s. 20(1)(c)(i) and its predecessor provisions have not favoured the view that a direct ineligible use of borrowed money ought to be overlooked whenever an indirect eligible use of funds can be found. See Sternthal and also Garneau Marine Co. v. Minister of National Revenue, 82 D.T.C. 1171 (T.R.B.)

31. In a similar vein, it has been held repeatedly that an individual cannot deduct interest paid on the mortgage of a personal residence even though he or she claims that the borrowing avoided the need to sell income‑producing investments. Some of the more recent cases include: Toolsie v. The Queen, [1986] 1 C.T.C. 216 (F.C.T.D.); Jordanov v. Minister of National Revenue, 86 D.T.C. 1136 (T.C.C.); Day v. Minister of National Revenue, 84 D.T.C. 1184 (T.C.C.); Eelkema v. Minister of National Revenue, 83 D.T.C. 253 (T.R.B.); Zanyk v. Minister of National Revenue, 81 D.T.C. 48 (T.R.B.); Holmann v. Minister of National Revenue, 79 D.T.C. 594 (T.R.B.); Huber v. Minister of National Revenue, 79 D.T.C. 936 (T.R.B.); Dorman v. Minister of National Revenue, 77 D.T.C. 251 (T.R.B.), and Verhoeven v. Minister of National Revenue, 75 D.T.C. 230 (T.R.B.) It has also been held in a number of cases that an estate cannot deduct interest paid on borrowings used to pay succession duties or taxes even though the estate claims to have borrowed in lieu of selling income‑producing investments: Shields v. Minister of National Revenue, 68 D.T.C. 668 (T.A.B.); Auld v. Minister of National Revenue; Cutten v. Minister of National Revenue, 56 D.T.C. 454 (T.A.B.); No. 228 v. Minister of National Revenue, 55 D.T.C. 39 (T.A.B.); No. 185 v. Minister of National Revenue, 54 D.T.C. 395 (T.A.B.)

32. The leading case from this Court on the availability of the interest deduction, Canada Safeway Ltd. v. Minister of National Revenue, also demonstrates a reluctance to overlook a clearly ineligible direct use of borrowed money in order to favour the taxpayer by characterizing the transaction on the basis of a less direct eligible use of borrowings. The taxpayer corporation in that case sought to deduct the interest on a series of debentures which the corporation used to finance the purchase of shares in another, related corporation. In the period in question, 1947‑1949, dividends from shares of Canadian corporations were exempted from taxable income. To the extent to which the debentures were used to produce dividend income from shares, the taxpayer was accordingly ineligible for the interest deduction. The taxpayer corporation argued however that the share purchase not only provided dividend income, but also increased the taxpayer's income from its existing business operations by giving it control over a wholesale supplier. This conferred a considerable advantage on the taxpayer relative to its competitors and allowed it to increase significantly its net income. Nevertheless, the Court held that the interest payments were not deductible, Locke J. dissenting. Rand J. stated, at p. 726:

No doubt there is in fact a causal connection between the purchase of the stock and the benefits ultimately received; but the statutory language cannot be extended to such a remote consequence; it could be carried to any length in a chain of subsidiaries; and to say that such a thing was envisaged by the ordinary expression used in the statute is to speculate and not interpret.

Referring to the interest expense deduction for borrowed money used for the purpose of earning income from business, Rand J. concluded, at p. 727:

What is aimed at by the section is an employment of the borrowed funds immediately within the company's business and not one that effects its purpose in such an indirect and remote manner.

Turning to borrowings used to generate income from property, he said at p. 728:

There is nothing in this language to extend the application to an acquisition of "power" annexed to stock, and to the indirect and remote effects upon the company of action taken in the course of business of the subsidiary.

33. Although the Canada Safeway case did not relate specifically to an alleged indirect use of funds to preserve income‑producing assets, the emphasis on directness of use of borrowed funds in the reasons of Rand J. is antithetical to the submission of the taxpayer in the present appeal.

34. 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 purchased with borrowed money may have been disposed of, while the debt incurred in its purchase remains unpaid.

35. 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.

36. I acknowledge, however, that just as there has been a recent trend away from strict construction of taxation statutes (see Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536, at pp. 573‑79, and The Queen v. Golden, [1986] 1 S.C.R. 209, at pp. 214‑15), 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: B.P. Australia Ltd. v. Commissioner of Taxation of Australia, [1966] A.C. 224 (P.C.), at p. 264. See also F. H. Jones Tobacco Sales Co., [1973] F.C. 825 (T.D.) at p. 834, [1973] C.T.C. 784, at p. 790, per Noël A.C.J.; Hallstroms Pty. Ltd. v. Federal Commissioner of Taxation (1946), 8 A.T.D. 190 (High Ct.), at p. 196, per Dixon J.; and Cochrane Estate v. Minister of National Revenue, 76 D.T.C. 1154 (T.R.B.), per Mr. A.W. Prociuk, Q.C.

37. This is, I believe, a laudable trend provided it is consistent with the text and purposes of the taxation statute. Assessment of 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.

38. This does not mean, however, that a deduction such as the interest deduction in s. 20(1)(c)(i), which by its very text is made available to the taxpayer in limited circumstances, is suddenly to lose all its strictures. It is not lightly to be assumed that an actual and direct use of borrowed money is any less real than the abstract and remote indirect uses which have, on occasion, been advanced by taxpayers in an effort to achieve a favourable characterization. In particular, I believe that despite the fact that it can be characterized as indirectly preserving income, borrowing money for an ineligible direct purpose ought not entitle a taxpayer to deduct interest payments.

39. The taxpayer in such a situation has doubly reduced his or her long run income‑earning capacity: first, by expending capital in a manner that does not produce taxable income; and second, by incurring debt financing charges. 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".

40. 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.

41. Before concluding, I wish to address one final argument raised by counsel for the Trust. It was submitted ‑‑ and the Crown generously conceded ‑‑ that the Trust would have obtained an interest deduction if it had sold assets to make the capital allocation and borrowed to replace them. Accordingly, it is argued, the Trust ought not to be precluded from an interest deduction merely because it achieved the same effect without the formalities of a sale and repurchase of assets. It would be a sufficient answer to this submission to point to the principle that the courts must deal with what the taxpayer actually did, and not what he might have done: Matheson v. The Queen, 74 D.T.C. 6176 (F.C.T.D.), per Mahoney J., at p. 6179. In any event, I admit to some doubt about the premise conceded by the Crown. If, for example, the Trust had sold a particular income‑producing asset, made the capital allocation to the beneficiary and repurchased the same asset, all within a brief interval of time, the courts might well consider the sale and repurchase to constitute a formality or a sham designed to conceal the essence of the transaction, namely that money was borrowed and used to fund a capital allocation to the beneficiary. In this regard, see Zwaig v. Minister of National Revenue, [1974] C.T.C. 2172 (T.R.B.), in which the taxpayer sold securities and used the proceeds to buy a life insurance policy. He then borrowed on the policy to repurchase the securities. Under s. 20(1)(c)(i) the use of borrowed money to purchase a life insurance policy is not a use entitling the taxpayer to an interest deduction. The Tax Review Board rightly disallowed the deduction sought for interest payments, notwithstanding that the form of the taxpayer's transactions created an aura of compliance with the requirements of the interest deduction provision. The characterization of taxpayers' transactions according to their true commercial and practical nature does not always favour the taxpayer. The taxpayer Trust in this appeal asks the Court for the benefit of a characterization based on the alleged commercial and practical nature of its transactions. At the same time, however, it seeks to have the commercial and practical nature of its transactions determined by reference to a hypothetical characterization which reflects the epitome of formalism. I cannot accept that it should be allowed to succeed.

42. It follows that I would allow the appeal and restore the assessments of the Minister of National Revenue, with costs in this Court, the Federal Court of Appeal and the Federal Court Trial Division.

Appeal allowed with costs.

Solicitor for the appellant: Roger Tassé, Ottawa.

Solicitors for the respondent: Phillips & Vineberg, Montréal.