Tennant v. M.N.R., [1996] 1 S.C.R. 305

John M. Tennant Appellant

v.

Her Majesty The Queen Respondent

Indexed as: Tennant v. M.N.R.

File No.: 24339.

1995: November 8; 1996: February 22.

Present: La Forest, Sopinka, Gonthier, Cory, McLachlin, Iacobucci and Major JJ.

on appeal from the federal court of appeal

Income tax ‑‑ Income from business or property ‑‑ Deductions ‑‑ Interest ‑‑ Taxpayer claiming interest paid on loan used to purchase shares ‑‑ Shares disposed of in rollover transaction ‑‑ Deduction allowed only for amount of interest on cost of replacement shares ‑‑ Whether full amount of interest deductible ‑‑ Income Tax Act, S.C. 1970‑71‑72, c. 63, s. 20(1)(c)(i).

The appellant used a $1 million bank loan to acquire 1 million common shares of a corporation at $1 per share. In 1985 he disposed of the shares to a holding company in a rollover transaction pursuant to s. 85 of the Income Tax Act. The declared fair market value of the original shares at the time of disposition was $1,000, as was the agreed purchase price and fair market value of the replacement shares. The appellant claimed a deduction for the full amount of the interest paid on the loan under s. 20(1)(c)(i) of the Act. The deduction was allowed by the Minister of National Revenue up to the time of the rollover, but for 1985 and 1986 the appellant was allowed a deduction only for the amount of interest that would have been paid if the loan had been equal to the cost to the appellant of the replacement shares, namely $1,000. His appeals from the reassessments for the 1985 and 1986 taxation years to the Federal Court, Trial Division and the Federal Court of Appeal were dismissed.

Held: The appeal should be allowed.

Under s. 20(1)(c)(i), interest can be deducted as an expense when the interest is paid or payable in the taxation year pursuant to a legal obligation to pay interest, and when the interest is payable on money borrowed for the purpose of earning income from a business or property. The purpose of the interest deduction provision is to encourage the accumulation of capital which would produce taxable income. In order to deduct interest payments, the taxpayer must establish a link between the current eligible use property, the proceeds of disposition of the original eligible use property, and the money that was borrowed to acquire the original eligible use property. This has been done in this case. Both the original and the replacement shares are directly traceable to the loan as the appellant reinvested all the proceeds of disposition. Money was borrowed and used by the appellant in order to produce investment income, and continued to be used for this purpose even though the investment vehicle for producing the income changed. The ability to deduct interest is not lost simply because the taxpayer sells the income‑producing property, as long as the taxpayer reinvests in an eligible use property. The basis for an interest deduction pursuant to s. 20(1)(c)(i) is not the value of the replacement property but the amount of the original loan. As long as the replacement property can be traced to the entire amount of the loan, then the entire amount of the interest payment may be deducted. If the replacement property can be traced to only a portion of the loan, then only a proportionate amount of the interest may be deducted. The view that the interest deduction is to be based on the value of the replacement property fails to further the purpose of s. 20(1)(c)(i). It also introduces an irrational asymmetry, since where the value of the new shares exceeds the amount of the loan, the basis of the interest deduction is the loan, not the value of the new shares. Finally, the taxpayer's utilization of the capital loss provisions should not bear on the deductibility of his current interest expense that results from financing the capital purchase of shares.

Cases Cited

Distinguished: Emerson v. The Queen, 86 D.T.C. 6184; referred to: Bronfman Trust v. The Queen, 1987 CanLII 76 (SCC), [1987] 1 S.C.R. 32; Kosmopoulos v. Constitution Insurance Co., 1987 CanLII 75 (SCC), [1987] 1 S.C.R. 2; Canada Safeway Ltd. v. Minister of National Revenue, 1957 CanLII 3 (SCC), [1957] S.C.R. 717.

Statutes and Regulations Cited

Income Tax Act, S.C. 1970‑71‑72, c. 63, ss. 18(1)(a), (b), 20(1)(c)(i), 38(c) [ad. 1977-78, c. 42, s. 2], 39(1)(c) [rep. & sub. 1979, c. 5, s. 11], 85.

Authors Cited

Hogg, Peter W., and Joanne E. Magee. Principles of Canadian Income Tax Law. Scarborough, Ont.: Carswell, 1995.

Krishna, Vern. "Interest Deductibility: More Form over Substance" (1993), 4 Can. Curr. Tax C17.

APPEAL from a judgment of the Federal Court of Appeal (1994), 175 N.R. 332, 94 D.T.C. 6505, [1994] 2 C.T.C. 113, upholding a decision of the Federal Court, Trial Division (1993), 1993 CanLII 17061 (FC), 59 F.T.R. 258, 93 D.T.C. 5067, [1993] 1 C.T.C. 148, dismissing the appellant's appeal from reassessments for the 1985 and 1986 taxation years. Appeal allowed.

Warren J. A. Mitchell, Q.C., and Karen R. Sharlow, for the appellant.

Johannes A. Van Iperen, Q.C., and Elizabeth Junkin, for the respondent.

The judgment of the Court was delivered by

I. Iacobucci J. -- This appeal involves the question of whether interest can be deducted by a taxpayer on a loan to purchase shares when the shares have been disposed of in a rollover transaction.

I. Facts

II. In May 1981, the appellant borrowed $1,000,000 from the Royal Bank of Canada. The appellant used the loan to acquire 1,000,000 common shares from treasury of an arm's length corporation, Realwest Energy Corporation, at $1 per share. Pursuant to the loan agreement between the appellant and the Royal Bank, the appellant had a legal obligation to pay interest on the loan to the Royal Bank, from May 1981 to December 31, 1986.

III. On July 25, 1985, the appellant disposed of the Realwest shares to an arm's length holding company called TWL Holdings Ltd. The Agreement of Purchase and Sale between the appellant and TWL was entered into pursuant to s. 85 of the Income Tax Act, S.C. 1970-71-72, c. 63 (the "Act"). The appellant received as consideration for the disposition of the Realwest shares 1,000 Class B common, non-voting, participating shares in TWL, with a par value of $1 per share. The declared fair market value of the Realwest shares at the time of disposition was $1,000. The agreed purchase price and fair market value of the 1,000 Class B TWL shares was $1,000.

IV. In disposing of his Realwest shares, the appellant planned to claim an allowable business investment loss pursuant to ss. 38(c) and 39(1)(c) of the Act. Although the nominal holder of the Realwest shares was TWL, the Realwest dividends that TWL received were passed on to the TWL shareholders who had formerly held Realwest shares. In substance, the appellant's economic interest in Realwest did not change subsequent to the disposition of the Realwest shares.

V. In April 1987, Realwest underwent a share restructuring. As a result, Realwest paid a dividend to its common shareholders, including TWL. On July 20, 1987, three months after the dividend payment, TWL used a portion of the Realwest dividend to pay a $316,232.62 dividend to the appellant on his TWL shares. The appellant used this dividend to make a partial repayment of the loan.

VI. Prior to July 25, 1985, the appellant claimed a deduction for the full amount of the interest paid to Royal Bank pursuant to s. 20(1)(c)(i), and the deduction was allowed. However, for 1985 and 1986, the appellant continued to claim a deduction for the full amount of the interest paid to the Royal Bank. The appellant was reassessed, and was allowed a s. 20(1)(c)(i) deduction only for the amount of interest that would have been paid if the loan had been equal to the cost to the appellant for the TWL shares, namely, $1,000.

VII. The appellant unsuccessfully appealed to both the Federal Court, Trial Division ((1993), 1993 CanLII 17061 (FC), 59 F.T.R. 258, 93 D.T.C. 5067, [1993] 1 C.T.C. 148) and the Federal Court of Appeal ((1994), 175 N.R. 332, 94 D.T.C. 6505, [1994] 2 C.T.C. 113).

II. Relevant Statutory Provisions

Income Tax Act, S.C. 1970-71-72, c. 63 (applicable to taxation years 1985 and 1986)

18. (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;

(b) an outlay, loss or replacement of capital, a payment on account of capital or an allowance in respect of depreciation, obsolescence or depletion except as expressly permitted by this Part;

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),

38.For the purposes of this Act,

(c) a taxpayer's allowable business investment loss for a taxation year from the disposition of any property is 1/2 of his business investment loss for the year from the disposition of that property.

39. (1) For the purposes of this Act,

(c) a taxpayer's business investment loss for a taxation year from the disposition of any property is the amount, if any, by which his capital loss for the year from a disposition after 1977

(i)to which subsection 50(1) applies, or

(ii) to a person with whom he was dealing at arm's length

of any property that is

(iii) a share of the capital stock of a Canadian-controlled private corporation, or

exceeds the aggregate of

III. Judgments Below

A. Federal Court, Trial Division (1993), [1993 CanLII 17061 (FC)](https://www.canlii.org/en/ca/fct/doc/1993/1993canlii17061/1993canlii17061.html), 59 F.T.R. 258

VIII. In considering whether the appellant was entitled, pursuant to s. 20(1)(c)(i) of the Act, to deduct the full amount of interest paid on the loan, Teitelbaum J. referred to Bronfman Trust v. The Queen, 1987 CanLII 76 (SCC), [1987] 1 S.C.R. 32. In particular, he noted (at pp. 264-65) Dickson C.J.'s articulation of the purpose of the interest deductibility section:

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...

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...

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...

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 on the inquiry must be centered on the use to which the taxpayer put the borrowed funds. [Emphasis added by Teitelbaum J.]

Teitelbaum J. emphasized that it is the current, direct use of the borrowed money that is to be the focus of any inquiry. An indirect use or the original use of the borrowed money is not relevant.

IX. Teitelbaum J. noted the appellant's position as follows (at pp. 265-66):

In the present case, the plaintiff [appellant] did not dispute the principle of law enunciated in Bronfman Trust, supra, which requires that a taxpayer trace the borrowed funds through to a current, direct and eligible use. However, the plaintiff claimed that the decision in Bronfman is distinguishable from the present facts at hand in that the tracing principle was only meant to apply in situations where the second investment was a separate income earning property which was purchased with the proceeds of the sale of the first investment.

Counsel for the plaintiff submitted that unlike the Bronfman Trust scenario, here the TWL shares were not a second, separate investment vehicle, apart from their ability to pass onto the plaintiff the dividends received from the Realwest shares. It was argued that at all times the source of income, which was acquired by the plaintiff using the $1,000,000 borrowed funds, remained intact. Accordingly, the s. 85 rollover did not change the real source of the plaintiff's income, rather it was only the form of the investment which was altered. Thus, counsel for the plaintiff contended that there is no need to point out the existence of an indirect source of income when, from an economic and practical point of view, the real source of income, being the Realwest shares, continued to exist.

Counsel for the plaintiff put great emphasis on the need for the court to look beyond the mere form of the investment to the substance and economic reality of the situation....

The plaintiff attached a considerable amount of importance to the fact that irrespective of the fact that after July 25, 1985 he did not retain an equitable or legal title to the Realwest shares, those shares and his remaining $999,000 investment remained intact as an economic interest because the dividends he received were dividends that flowed from Realwest through TWL, which would not have been possible had the plaintiff disposed of his shares to a third party and then used the proceeds thereof to acquire a second independent investment vehicle.

X. This characterization of the facts, in Teitelbaum J.'s view, was "fallacious". He found that the transfer of the Realwest shares to TWL pursuant to the s. 85 rollover did not "constitute a mere change in the form of the investment but a change of investment" (p. 266). In reaching this conclusion, he noted that the appellant had claimed a business investment loss under ss. 38(c) and 39(1)(c). These sections permit the taxpayer to claim a business investment loss that results from a disposition of property. Teitelbaum J. noted that when a person disposes of property, they have alienated the property to the point where they no longer retain a legal interest in that property. Accordingly, Teitelbaum J. stated that "once a taxpayer has `disposed' of an asset and claimed a business investment loss, he therefore should be precluded from maintaining the position that this original investment vehicle did not disappear, but merely changed its form" (p. 267). Teitelbaum J. also rejected the appellant's assertion that the transfer of the Realwest shares to TWL in exchange for 1,000 TWL shares merely constituted the insertion of a holding company between the appellant and Realwest.

XI. Teitelbaum J. then turned to consider what the appellant's source of income was after the transfer of the Realwest shares to TWL (at p. 267):

Having regard to the economic and legal reality of the transaction leads me to the conclusion that after July 25, 1985 the plaintiff's only source of income which remained was the TWL shares acquired at a cost of $1,000. Although the plaintiff was, as a shareholder of TWL, entitled to receive dividends from TWL whatever the source of such amounts to be, [sic] the plaintiff did not retain control over the flow of the dividend income from Realwest through TWL to himself. As such the plaintiff could not be said to have any legal or equitable interest in the Realwest shares. [Emphasis in original.]

The appellant asserted that TWL's assets in Realwest were a direct investment of the appellant, citing Kosmopoulos v. Constitution Insurance Co., 1987 CanLII 75 (SCC), [1987] 1 S.C.R. 2. However, Teitelbaum J. commented as follows (at p. 267):

In my opinion Kosmopoulos, supra, is inapplicable to the case at bar because the decision in Kosmopoulos was so affected by its facts. There the court was willing to lift the corporate veil and find that Mr. Kosmopoulos had a clear economic interest in those assets largely because he remained the sole shareholder of the corporation. Similarly, in Brierly, supra, the court lifted the corporate veil on the basis that the taxpayer remained a shareholder of the company from which he received dividends. These cases are distinguishable from the present set of facts since, here, the plaintiff is no longer a shareholder of Realwest but is merely one of many shareholders of TWL.

Accordingly, Teitelbaum J. was of the view (at pp. 267-68) that:

The principle of law, enunciated in Bronfman Trust, supra, as it relates to when a s. 20(1)(c) interest deduction may be made is clear, in that it is the direct and actual use of the borrowed money that is important and not an indirect use from which a benefit might be derived. Turning to the present facts at bar, I cannot accept the plaintiff's contention that the original $1,000,000 loan continued to be used during his 1985 and 1986 taxation years to earn income from property. After July 25, 1985, the only source from which the plaintiff continued to directly earn income, which related to the borrowed funds, was via his 1,000 TWL shares.

The fact that the plaintiff indirectly earned income from Realwest through TWL does not mean that the Realwest shares survived as a source of income to the plaintiff. It became a source of income for TWL.

On the facts as outlined, I am satisfied that it cannot be said that the full $1,000,000 Royal Bank loan continued to be used directly and actually by the plaintiff to earn income from the Realwest shares, as he, as of July 25, 1985 no longer legally or equitably owned the shares. They, the shares, were owned by TWL.

XII. Teitelbaum J. stated that, in his opinion, the language of s. 20(1)(c) is not ambiguous when read in conjunction with s. 20(1), and that it is clear "that the amount borrowed by the taxpayer must relate to a source from which the taxpayer has a reasonable expectation of profit" (p. 268). He concluded, therefore (at p. 268), that:

As previously stated the plaintiff upon effecting the s. 85 rollover disposed of his Realwest shares, and received as proceeds from the disposition 1,000 shares of TWL of a par value of $1 each. Therefore, I conclude that as of July 25, 1985, the plaintiff only invested $1000 of the $1,000,000 original investment and thus the TWL shares are the only source to which the interest expense can be applied.

XIII. In the event that his conclusion was incorrect, Teitelbaum J. made the following additional comments (at p. 268):

... the recent decision of the Supreme Court of Canada in Stubart Investments Ltd. v. [The Queen], 1984 CanLII 20 (SCC), [1984] 1 S.C.R. 536 ... is of assistance in regard to the appropriate method of interpreting taxing statutes. Mr. Justice Estey said, at p. [578], that the taxing statute should be interpreted "with the words used therein read in their entire context and in harmony with the scheme of the Act, the object of the Act, and the intention of Parliament"....

Therefore, since the plaintiff has claimed the allowable business investment loss he is deemed to have disposed of the Realwest shares. I believe it would be contrary to Parliament's intent to allow a taxpayer to, at one level, defer a capital gain where a disposition of property has occurred, and at another level to allow the taxpayer to bring themselves within the interest deductibility provision that requires that the source of the income continue to exist.

B. Federal Court of Appeal (1994), 175 N.R. 332

XIV. McDonald J.A., for the court, gave brief reasons, which I set out below:

These are appeals from a reported decision of the Trial Division (1993 CanLII 17061 (FC), 59 F.T.R. 258; 93 D.T.C. 5067) which dismissed appeals from the reassessment of the appellant's 1985 and 1986 income tax returns.

We are of the view that the learned trial judge was correct in his conclusion that the Realwest shares ceased to be a current source of income to the appellant after July 25, 1985, and that the interest expense for monies borrowed to acquire them was no longer deductible except to the extent of the value of the TWL shares for which they were exchanged. (Bronfman (Phyllis Barbara) Trust v. Minister of National Revenue (1987), 1987 CanLII 76 (SCC), 71 N.R. 134; 87 D.T.C. 5059 (S.C.C.)).

We are in substantial agreement with the Reasons for Judgment of the learned trial judge but would observe that the results oriented approach to interpreting the Income Tax Act evidenced by the following statement is not acceptable (Antosko v. Minister of National Revenue (1994), 168 N.R. 16 (S.C.C.)):

Therefore, since the plaintiff has claimed the allowable business investment loss he is deemed to have disposed of the Realwest shares. I believe it would be contrary to Parliament's intent to allow a taxpayer to, at one level, defer a capital gain where a disposition of property has occurred, and at another level to allow the taxpayer to bring themselves within the interest deductibility provision that requires that the source of the income continue to exist.

The appeals will be dismissed with costs.

IV. Issue on Appeal

Is the appellant entitled by s. 20(1)(c)(i) of the Act to deduct the full amount of interest paid on the loan after disposing of the shares on July 25, 1985 pursuant to a s. 85 rollover for the 1,000 Class B shares of TWL?

V. Analysis

XV. At the outset, I wish to point out that there was no evidence or suggestion before this Court of any tax evasion or improper avoidance scheme on the part of the taxpayer. This appeal involves only the question of whether the deduction of interest on the $1,000,000 loan comes within s. 20(1)(c)(i).

XVI. In my opinion, s. 20(1)(c)(i) is not ambiguous. It clearly states that interest can be deducted as an expense when the interest is paid or payable in the taxation year pursuant to a legal obligation to pay interest, and when the interest is payable on money borrowed for the purpose of earning income from a business or property. The purpose of the interest deduction provision is to encourage the accumulation of capital which would produce taxable income, as Dickson C.J. noted in Bronfman Trust, supra, at p. 45. But for s. 20(1)(c)(i), the deduction of interest payments would be prevented by s. 18(1)(b) (Canada Safeway Ltd. v. Minister of National Revenue, 1957 CanLII 3 (SCC), [1957] S.C.R. 717; some commentators suggest that Canada Safeway is wrongly decided; see P. W. Hogg and J. E. Magee, Principles of Canadian Income Tax Law (1995), at p. 221, note 36; however, I need not address that issue in these reasons).

XVII. In Bronfman Trust, Dickson C.J. commented on eligible and ineligible uses of borrowed money within the context of s. 20(1)(c)(i), at pp. 45-46:

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....

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. [Emphasis in original.]

Dickson C.J. also pointed to a distinction between the original and the current use of borrowed money (at p. 47):

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.... A taxpayer cannot continue to deduct interest payments merely because the original use of borrowed money was to purchase income-bearing assets, after he or she has sold those assets and put the proceeds of sale to an ineligible use. To permit the taxpayer to do so would result in the borrowing of funds to finance the purchase of income-earning property which could be re-sold immediately without affecting the deductibility of interest payments for an indefinite period thereafter.

Conversely, a taxpayer who uses or intends to use borrowed money for an ineligible purpose, but later uses the funds to earn non-exempt income from a business or property, ought not to be deprived of the deduction for the current, eligible use....

XVIII. Accordingly, in order to deduct interest payments, the taxpayer must establish a link between the current eligible use property, the proceeds of disposition of the original eligible use property, and the money that was borrowed to acquire the original eligible use property. On the facts of this case, in order to deduct the interest payments, the appellant must establish a link between the TWL shares he now owns, the proceeds of disposition of the original shares, and the money that was borrowed to acquire the original shares. In my view, this has been done, as both the original shares and the TWL shares are directly traceable to the loan. The respondent has argued that it is only the amount of $1,000 that can be traced to an eligible use, and that the appellant, in disposing of his Realwest shares, did not merely alter the form of the investment, but "reduced his investment capital and therewith his income earning source to $1,000, which was the cost of the TWL shares".

XIX. With respect, this view should be rejected. Money was borrowed and used by the taxpayer in order to produce investment income, and continued to be used for this purpose even though the investment vehicle for producing the income changed. The fact that the investment has changed is not of any consequence as Dickson C.J. accepted in Bronfman Trust; otherwise his comments and the examples he gave in that case make no sense. The original Realwest shares, the first source of income, were exchanged for the TWL shares, a replacement source. In a sense, the first source continued in a new form, as both the Realwest and the TWL shares are directly and fully traceable to the loan, as all the proceeds of disposition were reinvested in the second source.

XX. To repeat, it is implicit in the principles outlined in Bronfman Trust that the ability to deduct interest is not lost simply because the taxpayer sells the income-producing property, as long as the taxpayer reinvests in an eligible use property. However, shares depreciate and appreciate in value, complicating the question of interest deductions. The appellant has replaced one eligible use property with another, and both are directly traceable to the same loan, as the appellant reinvested all the proceeds of disposition. The lower courts, however, would determine the amount of the appellant's interest deduction on the value of the new shares, rather than the amount of the loan. However, and I will return to this point below, pursuant to this approach, even if the new shares increase in value over time to the amount of the original loan, the amount of the interest deduction would not increase. Thus the issue to be resolved is whether the amount of the interest deduction should be determined on the basis of the amount of the original loan, or the value of the newly acquired shares; it is this question relating to s. 20(1)(c)(i) that has not been settled in the jurisprudence.

XXI. The courts below were of the view that, as the TWL shares had a fair market value of only $1,000, then only $1,000 of the original loan continued to be used for the purpose of earning income from property, pursuant to Emerson v. The Queen, 86 D.T.C. 6184 (F.C.A.). In Emerson, the taxpayer had borrowed $100,000 for the purchase of shares from three small corporations. He sold the shares for $35,000 and borrowed $63,750 to repay the original bank loan. The taxpayer was permitted to deduct the interest on the original loan, but not the interest on the second loan. The reason for this was that the source of income no longer existed. In my view, the Emerson case is not of any application to these facts. Emerson is distinguishable as the proceeds of disposition in that case were not reinvested into a second eligible use property, unlike the case at hand.

XXII. As Professor Krishna comments in "Interest Deductibility: More Form over Substance" (1993), 4 Can. Curr. Tax C17:

The Federal Court [in Tennant] looked at the direct and current use of the funds and the value of the substituted property purchased with the borrowed money. The result is this: if an investor borrows money to purchase shares, his interest expense on the borrowing remains deductible so long as he holds the shares even if they lose all value. If he bails out of a bad investment and purchases substitute shares, the interest will only be deductible to the extent of the cost of the new shares. This is so, even if the new shares increase in value to the cost of the original investment. The Emerson rule may be logical from a technical source perspective but it does little to promote the commercial and economic substance of the transactions. [Emphasis in original.]

XXIII. In my opinion, the basis for an interest deduction pursuant to s. 20(1)(c)(i) is not the value of the replacement property, in this case the TWL shares, but the amount of the original loan. The wording of s. 20(1)(c)(i) itself supports this interpretation. The deduction is based on the amount of interest paid in the year, or payable in respect of the year, pursuant to a legal obligation to pay interest on that proportion of "borrowed money used for the purpose of earning income from a business or property" that is "wholly applicable to that source". As long as the replacement property can be traced to the entire amount of the loan, then the entire amount of the interest payment may be deducted. If the replacement property can be traced to only a portion of the loan, then only a proportionate amount of the interest may be deducted. Clearly, however, the amount of interest to be deducted relates to the amount of the loan, and not the value of the replacement property.

XXIV. The approach taken by the courts below fails to further the purpose of s. 20(1)(c)(i), which, as noted earlier, is to encourage the accumulation of capital which would produce taxable income. Consider the effect of the approach taken by the lower courts when applied to the following example. An investor is attracted by the interest deduction provision and borrows $25,000 to purchase shares. However, the value of the shares declines significantly, and as a prudent investor, the individual sells the original shares for their current value of, for example, $10,000. The investor then acquires new shares, worth $10,000, with the proceeds. The taxpayer in this case is still liable for the $25,000 loan, but, pursuant to the approach of the lower courts, can only deduct interest on the value of the new shares, $10,000. This approach is not likely to encourage the accumulation of capital that produces taxable income, the very purpose of the interest deduction provision. Basing the allowable interest deduction on the amount of the loan, rather than the value of the replacement asset, is more in keeping with the desire to produce taxable income.

XXV. In further support of the view that the interest deduction is to be based on the amount of the loan rather than the value of the replacement property is that the latter approach introduces an irrational asymmetry. Consider the following example. A taxpayer borrows $25,000 to purchase eligible use shares, and claims the interest deduction. The shares increase in value, and the taxpayer sells them for $30,000, using the proceeds to purchase new shares worth $30,000. The taxpayer would then have to claim a capital gain of $5,000, but would also be entitled to deduct interest on the $25,000 loan. Clearly, the taxpayer would not be permitted to claim an interest deduction on the value of the new shares, that is $30,000, in excess of the amount of the loan. Where the value of the new shares exceeds the amount of the loan, the basis of the interest deduction is the loan, not the value of the new shares. Why would the basis of the interest deduction be any different simply because the original shares decline, rather than increase, in value? The value of the replacement property is in effect irrelevant to the deductibility of the interest. Consequently, to base the interest deduction on the value of the new shares is misguided, and leads to an unacceptable asymmetry in the application of s. 20(1)(c)(i), which should be avoided unless otherwise necessary. As long as the taxpayer establishes a link between the current shares, the proceeds of disposition of the original shares, and the money that was borrowed to acquire the original eligible use property, it is in keeping with the interest deduction provision to permit the taxpayer to continue to deduct the interest payments for the full amount of the original loan, regardless of the value or cost of the newly acquired shares. Of course, where the taxpayer reinvests only a portion of the proceeds of disposition of the original eligible use property, then interest can only be deducted for the relevant portion of the loan.

XXVI. Further, the approach taken by the courts below in the instant appeal fails to reflect the economic reality of the situation. The appellant in this case has reinvested all the proceeds of disposition of the Realwest shares into the purchase of the TWL shares, and both these transactions are directly traceable to the original loan. As Dickson C.J. stated in Bronfman Trust, at pp. 52-53, courts should strive to focus on the economic realities of a transaction, rather than juristic classifications:

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 CanLII 20 (SCC), [1984] 1 S.C.R. 536, at pp. 573-79, and The Queen v. Golden, 1986 CanLII 50 (SCC), [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....

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.

XXVII. Finally, I am in agreement with the Court of Appeal's finding that the trial judge's consideration of capital gains and loss issues in the context of s. 20(1)(c)(i) is an unacceptable, results-oriented approach. I note the comments of Professor Krishna, supra, at p. C18, in this regard:

The loss on the disposition of the original shares was a real economic loss of the capital value of the shares. The capital loss would have occurred even if the shares had been purchased for cash. The interest cost of the original borrowing continued regardless of the taxpayer's capital loss. The two costs, capital and interest, are clearly distinct and the taxpayer's utilization of the capital loss provisions should not bear on the deductibility of his current interest expense that results from financing the capital purchase of the shares. [Emphasis in original.]

VI. Conclusion and Disposition

XXVIII. It is my conclusion that the interest on the loan remained qualified for a deduction under s. 20(1)(c)(i) after the exchange of the Realwest shares for the TWL shares, and that the taxpayer is entitled to deduct the full amount of the interest on the loan for the taxation years 1985 and 1986. The proceeds of the disposition of the Realwest shares were used in their entirety to acquire the TWL shares. Both transactions are directly traceable to the loan. The extent of the interest deduction should be based on the amount of the loan, not the value or cost of the replacement property.

XXIX. Accordingly, I would allow the appeal with costs throughout, set aside the judgment of the Federal Court of Appeal and the reassessments for the taxpayer's 1985 and 1986 taxation years, and remit the matter back to the Minister of National Revenue for reassessment in conformity with these reasons.

Appeal allowed with costs.

Solicitors for the appellant: Thorsteinssons, Vancouver.

Solicitor for the respondent: George Thomson, Ottawa.