Judgments

[1997] 2 F.C. 471

A-434-94 (T-2001-90)

74712 Alberta Ltd. (formerly Cal-Gas & Equipment Ltd.) (Appellant)

v.

Her Majesty the Queen (Respondent)

Indexed as: 74712 Alberta Ltd. v. M.N.R. (C.A.)

Court of Appeal, Strayer, Linden and Robertson JJ.A.—Calgary, November 21, 1996; Ottawa, January 29, 1997.

Income tax — Income calculation — Deductions — Appeal from Trial Division judgment dismissing appeal from Tax Court decision dismissing appeal from reassessment under Income Tax Act, s. 20(1)(c)(i) (permitting deduction of interest on borrowed money used to earn non-exempt income from business or property) — Parent company obtaining $7.4 million credit facility with CIBC of which $3.3 million available as line of credit to taxpayer, related companies — Remainder representing pre-existing indebtedness of group — Taxpayer guaranteeing loan — Borrowing money to honour guarantee — Appeal dismissed — Purpose of loan to honour guarantee, not earn income — Borrowed funds not used to produce income — Interpretation Bulletin IT-445 (permitting deduction of interest on money borrowed to honour guarantee, given for “adequate consideration”) inapplicable as inadequate consideration — Robertson J.A.’s concurring reasons analysis of Bronfman v. The Queen indicating S.C.C. recognizing possibility of exceptions to direct-use rule — IT-445 restatement of reasonable expectation of profit requirement.

This was an appeal from a Trial Division judgment dismissing an appeal from the Tax Court’s dismissal of an appeal from a reassessment disallowing the deduction of interest payments on a loan to discharge the appellant’s guarantee of the indebtedness of its parent corporation. The appellant is one of a group of corporations of which Trennd became the parent after restructuring in 1979. Prior to the restructuring, the appellant had an opportunity to enter into a lucrative contract with Husky Oil, but in order to exploit the opportunity, it needed to purchase equipment. To that end, it borrowed money from the CIBC. In 1980, Trennd consolidated the financial arrangements of the sister corporations into a $7.4 million credit facility with the CIBC, which required cross-guarantees by members of the group, including the appellant. Of that amount $3.3 million was made available as an operating line of credit to which the appellant and its related companies had access. The remainder represented the pre-existing indebtedness of the Trennd companies, including that of the appellant. In 1981 and 1982 the CIBC called on its guarantees. The appellant borrowed $1.7 million from Wells Fargo to satisfy its guarantee and deducted the interest payments pursuant to Income Tax Act, subparagraph 20(1)(c)(i), which permits the deduction of amounts paid pursuant to a legal obligation to pay interest on borrowed money used to earn non-exempt income from a business or property. The Minister denied the deduction. The Tax Court dismissed taxpayer’s appeal, holding that while it would not have been feasible for Cal-Gas to sell off its assets in order to satisfy its guarantee, the true purpose and direct use of the loan was to pay off a debt owed by Trennd. This finding was based on an application of Bronfman Trust v. The Queen, according to which, absent “exceptional circumstances”, the taxpayer must demonstrate that its bona fide intention was to borrow the money for the direct purpose of earning income in order to come within subparagraph 20(1)(c)(i). It is not enough to trace the borrowed money to an indirect purpose of earning income. The Tax Court held that the circumstances were not exceptional. The Trial Judge reached the same result as the Tax Court on the preservation of assets argument, and rejected the alternative argument that the purpose of the loan should be traced back to the provision of the credit facility which enabled the appellant to enter into the Husky Oil contract. The Trial Judge found that the taxpayer had already started to reap the rewards of the contract and was financially independent before the consolidated credit facility was established and that the appellant had received inadequate consideration for the guarantee because the only new thing which the credit facility extended to the taxpayer was an operating line of credit of which it ultimately made little use. Consequently, Interpretation Bulletin IT-445, which states that “interest expense on money borrowed to honour a guarantee which had been `given for adequate consideration’ is generally deductible”, was not applicable. The Trial Division Judge agreed that the true purpose of the loan was to help out the parent corporation. As the taxpayer was not in the business of giving and paying guarantees, it could not deduct interest payments on loans for this purpose.

The issue was whether the interest payments were on “borrowed money used for the purpose of earning income from a business or property” as stipulated in subparagraph 20(1)(c)(i).

Held, the appeal should be dismissed.

Per Linden J.A. (Strayer J.A. concurring): The interest payment deduction allowed by subparagraph 20(1)(c)(i) has been strictly applied by the courts because such payments are usually made to increase the capital holdings of taxpayers. Without statutory authorization, no deduction would be permitted for these payments. However, because Canadian fiscal policy seeks to encourage the augmentation of income earning potential, certain deductions for interest are permitted in paragraph 20(1)(c). The Trial Judge correctly concluded that the loan was taken to honour the taxpayer’s guarantee and was not taken or used directly for the purpose of earning income from business or property. The loan was not one from which the taxpayer might earn profit, and hence any interest paid thereon was not deductible. Even if the initial trigger for the borrowing was the guarantee, the borrowed money was not actually used to produce income, but to pay off the Trennd debts. Any remedy for the taxpayer must come from Parliament or the Supreme Court of Canada.

IT-445 did not apply because there was inadequate consideration for the loan and the use of the money was not the use to which the funds were originally put.

Per Robertson J.A.: Interest payments on the $1.7 million bank loan were not deductible from income.

Interpretation Bulletin No. IT-445 presents a direct challenge to the ruling in Bronfman that interest payments on funds borrowed for a direct ineligible use are not deductible from income. But, the reasoning of the Supreme Court in Bronfman left open the possibility of recognizing exceptions to the direct-use rule for the following reasons. (1) Such an exceptional category accords with the object and purpose of subparagraph 20(1)(c)(i), which was to lessen the impact of paragraph 18(1)(b) and encourage the accumulation of capital used in the production of taxable income. (2) Recognition of an exceptional category does not negate the policy objective of tax equity underlying the existence of the direct-use rule. To allow deduction of interest payments on the basis of an indirect eligible use, such as the preservation of income-producing assets, when the direct use serves no economic purpose, would provide a windfall to affluent Canadians, and be unfair to less wealthy taxpayers. (3) The Supreme Court in Bronfman did not expressly overrule Trans-Prairie Pipelines, Ltd. v. M.N.R., [1970] C.T.C. 537 (Ex. Ct.), wherein it was held that a taxpayer could deduct from income interest payments on funds borrowed for an indirect eligible use. This supports acceptance of a discrete category of exceptions to the general rule on deductibility of interest. (4) Finally, the exceptional category accords with the directive in Bronfman that transactions be viewed with an eye to “commercial realities”. Commercial reality is that corporate borrowing is as integral to the income-earning process as is the provision of third-party security. The same could not be said of a capital allocation to a beneficiary under a trust.

Bronfman identified two criteria to be applied when determining whether interest payments on funds borrowed for a direct ineligible use are deductible: (1) that the taxpayer establish a bona fide purpose to use the funds to earn income, and (2) a reasonable expectation that the borrowing would yield income in excess of the interest expense. IT-445 is simply another way of restating the reasonable expectation of profit requirement. Thus there was a legal foundation for IT-445. Accordingly, interest paid on funds borrowed to honour guarantees given for adequate consideration may be deducted from income even though the use of such funds has only an indirect effect on the taxpayer’s income-earning capacity. The indirect eligible use is therefore not too remote in all instances.

Regardless of whether “eligibility of use” is assessed as of the date when the guarantee was granted or when the funds were borrowed to honour the guarantee, the taxpayer was unable to satisfy the direct-use rule. The granting of the guarantee was intended to facilitate the income-earning capacity of the principal debtor, Trennd, not the guarantor, Cal-Gas. The borrowed funds were applied to a direct ineligible use.

In certain instances funds borrowed for the purpose of satisfying the debt of a third party may not offend the direct-use rule. There may be cases where a taxpayer is able to establish that he had access to and did actually receive proceeds of the loan guaranteed. In such instances the borrowing is directly related to the income-earning capacity of the guarantor. Had Cal-Gas been able to establish that all or a portion of the $1.7 million it was required to pay on the guarantee related to its own indebtedness, interest payments could have been deducted under subparagraph 20(1)(c)(i). The debt being guaranteed would be that of Cal-Gas. However, Cal-Gas had repaid all the monies which it owed Trennd by the time the Bank demanded payment. The right to deduct interest payments must be limited to that portion which can be traced directly to the indebtedness incurred by the guarantor in the course of earning income and which remains outstanding when the guarantee is called.

The interest payments were not deductible from income unless the exceptional circumstances qualification articulated in Bronfman was applicable. But Cal-Gas received inadequate consideration from Trennd in return for the granting of its guarantee. The adequacy issue must be approached in terms of whether two reasonable and unrelated business entities would have agreed to contractual terms such as were agreed to in this case. Were it not for the fact that Cal-Gas and Trennd were related companies, it is doubtful that Cal-Gas would have granted the guarantee on the basis of what it received and having regard to the potential liability that it had assumed. Cal-Gas failed to establish that the benefits to be derived from the availability of the credit facility outweighed the potential risk and magnitude of loss arising from the granting of the guarantee. Any income-earning purpose attributable to the granting of the guarantee is, in the absence of persuasive evidence to the contrary, too remote.

The Trial Judge correctly rejected the business necessity argument. It was not established on a balance of probabilities that the corporate reorganization and the establishment of the credit facility were effected to permit Cal-Gas to exploit the Husky Oil contract.

STATUTES AND REGULATIONS JUDICIALLY CONSIDERED

Income Tax Act, R.S.C., 1985 (5th Supp.), c. 1, s. 20.1 (as enacted by S.C. 1994, c. 21, s. 13).

Income Tax Act, S.C. 1970-71-72, c. 63, ss. 18(1)(a),(b), 20(1)(c)(i).

Income War Tax Act, R.S.C. 1927, c. 97, s. 6(1)(a), (5) (as enacted by S.C. 1939, c. 46, s. 8).

The Income Tax Act, S.C. 1948, c. 52, s. 12(1)(b).

CASES JUDICIALLY CONSIDERED

APPLIED:

Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32; (1987), 36 D.L.R. (4th) 197; [1987] 1 C.T.C. 117; 87 DTC 5059; 25 E.T.R. 13; 71 N.R. 134; Interior Breweries Ltd. v. Minister of National Revenue, [1955] Ex. C.R. 165; [1955] C.T.C. 143; (1955), 55 DTC 1090; McLaws v. M.N.R., [1974] S.C.R. 887; (1972), 27 D.L.R. (3d) 137; [1972] C.T.C. 165; 72 DTC 6149.

DISTINGUISHED:

Imperial Oil Ltd. v. Minister of National Revenue, [1947] Ex. C.R. 527; [1948] 1 D.L.R. 305; [1947] C.T.C. 353; (1947), 3 DTC 1090; Tonn v. Canada, [1996] 2 F.C. 73 [1996] 1 C.T.C. 205; (1995), 96 DTC 6001; 191 N.R. 182 (C.A.).

CONSIDERED:

Bowater Canadian Ltd. v. The Queen, [1987] 2 C.T.C. 47; (1987), 87 DTC 5287; 78 N.R. 140 (F.C.A.); Emerson (R.I.) v. The Queen, [1986] 1 C.T.C. 422; (1986), 86 DTC 6184 (F.C.A.); leave to appeal refused [1986] 1 S.C.R. viii; (1986), 70 N.R. 160; Canada Safeway Limited v. The Minister of National Revenue, [1957] S.C.R. 717; (1957), 11 D.L.R. (2d) 1; [1957] C.T.C. 335; 57 DTC 1239; Minister of National Revenue v. Steer, [1967] S.C.R. 34; [1966] C.T.C. 731; (1966), 66 DTC 5481; Trans-Prairie Pipelines, Ltd. v. M.N.R., [1970] C.T.C. 537; (1970), 70 DTC 6351 (Ex. Ct.); M.N.R. v. Attaie, [1990] 3 F.C. 325 [1990] 2 C.T.C. 157; (1990), 90 DTC 6413; 109 N.R. 232 (C.A.); Mark Resources Inc. v. Canada, [1993] C.T.C. 2259; (1993), 93 DTC 1004 (T.C.C.); Sternthal, J v The Queen, [1974] CTC 851; (1974), 74 DTC 6646 (F.C.T.D.); Auld v. Minister of National Revenue (1962), 62 DTC 27 (T.A.B.).

REFERRED TO:

Tennant v. M.N.R., [1996] 1 S.C.R. 305; (1996), 132 D.L.R. (4th) 1; [1996] 1 C.T.C. 290; 96 DTC 6121; 192 N.R. 365; Herald and Weekly Times Ltd. v. Federal Commissioner of Taxation (1932), 48 C.L.R. 113 (Aust. H.C.); Stein et al. v. “Kathy K” et al. (The Ship), [1976] 2 S.C.R. 802; (1975), 62 D.L.R. (3d) 1; 6 N.R. 359; Lyons (D M) v MNR, [1984] CTC 2690; (1984), 84 DTC 1633 (T.C.C.); Corbett v. Canada, [1997] 1 F.C. 386(C.A.); Symes v. Canada, [1993] 4 S.C.R. 695; (1993), 110 D.L.R. (4th) 470; 19 C.R.R. (2d) 1; [1994] 1 C.T.C. 40; 94 DTC 6001; 161 N.R. 243; Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536; (1984), 10 D.L.R. (4th) 1; [1984] CTC 294; 84 DTC 6305; 53 N.R. 241; Schwartz v. Canada, [1996] 1 S.C.R. 254; (1996), 113 D.L.R. (4th) 289; 17 C.C.E.L. (2d) 141; 10 C.C.P.B. 213; [1996] 1 C.T.C. 303; 96 DTC 6103; 193 N.R. 241; Canada v. Placer Dome Inc., [1997] 1 F.C. 780(C.A.); The Commissioners of Inland Revenue v. Holder (Sir H. C., Bart) and Holder (J. A.) (1932), 16 T.C. 540 (H.L.); Canada v. MerBan Capital Corp., [1989] 2 C.T.C. 246; (1989), 89 DTC 5404; 100 N.R. 383 (F.C.A.).

AUTHORS CITED

Arnold, B. J. “Is Interest a Capital Expense?” (1992), 40 Can. Tax J. 533.

Canada. Department of National Revenue. Taxation. Interpretation Bulletin IT-445, February 21, 1981.

Couzin, R. et al. “Tax Treatment of Interest: Bronfman Trust and the June 2, 1987 Release” in Corporate Management Tax Conference, Toronto: Canadian Tax Foundation, 1987.

Dixon, Gordon D. and Brian J. Arnold. “Rubbing Salt into the Wound: The Denial of the Interest Deduction After the Loss of a Source of Income” (1991), 39 Can. Tax J. 1473.

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

Jones, Avery J. F. “Nothing Either Good or Bad, but Thinking Makes It So—The Mental Element in Anti-Avoidance Legislation” (1983), British Tax Review 9.

Krishna, Vern. The Fundamentals of Canadian Income Tax, 5th ed. Toronto: Carswell, 1995.

APPEAL from Trial Division judgment ([1994] 2 C.T.C. 191; (1994), 94 DTC 6392; 78 F.T.R. 259) dismissing appeal from Tax Court’s ([1990] 2 C.T.C. 2001; (1990), 90 DTC 1407) dismissal of appeal from reassessment disallowing deduction of interest payments on loan to discharge guarantee of indebtedness of parent corporation under Income Tax Act, subparagraph 20(1)(c)(i). Appeal dismissed.

COUNSEL:

Cliff D. O’Brien, Q.C. and Alnasir Meghji for appellant.

Michael E. Curley and Rhonda Nahorniak for respondent.

SOLICITORS:

Bennett Jones Verchere, Calgary, for appellant.

Deputy Attorney General of Canada for respondent.

The following are the reasons for judgment rendered in English by

Linden J.A.: The issue in this case is whether interest payments made by the appellant in 1983, 1984 and 1985 on a loan of $1.7 million from Wells Fargo Bank were deductible pursuant to subparagraph 20(1)(c)(i) of the Income Tax Act.[1]

This $1.7 million loan to Cal-Gas & Equipment Ltd. (Cal-Gas, now 74712 Alberta Ltd.) was used by the appellant to discharge its guarantee of the indebtedness of its parent corporation Trennd Investments (1979) Ltd. (Trennd) to the Canadian Imperial Bank of Commerce (CIBC).

What must be decided on this appeal is whether these payments of interest were on “borrowed money used for the purpose of earning income from a business or property” as stipulated in subparagraph 20(1)(c )(i) which reads:

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),

The Tax Court Judge denied the deduction [[1990] 2 C.T.C. 2001]. The Trial Division of this Court, after a trial de novo, also denied the deduction [[1994] 2 C.T.C. 191]. Now this Court agrees that these payments do not come within the definition of subparagraph 20(1)(c)(i).

Background Facts

Cal-Gas is a propane and equipment supplier. It is one of a group of corporations largely owned and operated by a single person, John Corbett Anderson (Anderson), of which Trennd became the parent after a restructuring in 1979. The reason for this restructuring, the financial situation of Cal-Gas at the time of the restructuring, and the effect of the restructuring on Cal-Gas’ relationship with the CIBC are said to be relevant to the determination of this appeal. The corporate restructuring which placed Trennd at the head of the group of companies owned by Anderson was for the purpose of making Trennd the banker for the group. Just prior to the restructuring, Cal-Gas, which had been suffering financially, had an opportunity to enter into a very large and lucrative contract with Husky Oil to supply it with propane in the Lloydminster area. In order to exploit this opportunity, Cal-Gas needed to purchase equipment and so it entered into certain credit arrangements with the CIBC under the guarantee of one of its sister companies in 1979. In 1980, following the restructuring, the financial arrangements of the various sister corporations were consolidated by the CIBC into a credit facility which required cross-guarantees by members of the Trennd organization, including Cal-Gas. In return, the Trennd group received total financing of approximately $7.4 million, which included the indebtedness which Cal-Gas had already incurred in its initial financing, an amount of $2,016,498. Cal-Gas also gained access to increased operating loans in the name of Trennd up to a total of $3.3 million.

Following the establishment of the credit facility, however, the Trennd organization ran into serious financial trouble. Cal-Gas, which was originally a weak link in the group, was the only member which continued to thrive. As a result, in 198l and 1982, the CIBC called on its guarantees by members of the Trennd organization, including Cal-Gas and Anderson personally. Cal-Gas borrowed $l,700,000 from Wells Fargo in order to satisfy its guarantee of Trennd’s liabilities. The money was paid directly to the CIBC and a non-interest bearing promissory note was given to Cal-Gas by Trennd. Relieved of its obligation, Cal-Gas continued to do business. A further $500,000 was paid to the CIBC by Anderson personally in order to satisfy the remainder of the outstanding debt.

Decision of the Tax Court Judge

In its first effort, Cal-Gas argued before the Tax Court that “the true purpose of the borrowed money was for Cal-Gas to maintain the use of its unsaleable assets (including its accounts receivable) or to preserve its assets (i.e. its very existence) and therefore was a business purpose”. Although the Tax Court Judge agreed with the appellant that it would not have been feasible for Cal-Gas to sell off its assets in order to satisfy its guarantee, he nonetheless concluded that the true purpose and direct use of the borrowed money was to pay off a debt owed to the CIBC by Trennd. He based this finding on an application of Bronfman Trust v. The Queen.[2] According to this case, in order for a taxpayer to escape the prohibition on deductibility set out in paragraph 18(1)(b) via subparagraph 20(1)(c)(i), absent “exceptional circumstances”, it must demonstrate that its bona fide intention was to borrow the money for the direct purpose of earning income. It is not enough to trace the borrowed money to an indirect purpose of earning income. Following this reasoning, the Tax Court Judge held that [at pages 2004-2005]:

Even though the Supreme Court of Canada acknowledged that there might be exceptional circumstances where it would be appropriate to allow the taxpayer to deduct interest on funds borrowed for an ineligible use because of an indirect effect on the taxpayer’s income-earning capacity, and Cal-Gas had no other business alternative but to borrow the money, the circumstances herein are not those exceptional to warrant this Court from not applying the principal laid down in Bronfman, supra.

As a result, the Tax Court Judge disallowed the deduction under subparagraph 20(1)(c)(i).

Decision of the Trial Judge

Having failed to persuade the Tax Court that the true purpose of the Wells Fargo loan was to preserve Cal-Gas’ assets and thus sufficient to fit it within subparagraph 20(1)(c)(i), the appellant completely recast its submissions before the Federal Court Trial Division. Here, it argued that the purpose of the loan should be traced back to the provision of the credit facility which enabled Cal-Gas to enter into the profitable business with Husky in Lloydminster. Provision of the guarantee which was eventually called on by the CIBC was, on this logic, a critical step in allowing Cal-Gas to earn income.

After reaching the same result as the Tax Court Judge on the preservation of assets argument, the Trial Judge also rejected the alternative characterization of purpose on two grounds. First, he found that Cal-Gas had already started to reap the rewards of the Husky opportunity and was financially independent before the consolidated credit facility was established with the CIBC. The Trial Judge further found that Cal-Gas received inadequate consideration for the guarantee which later required it to make payments to CIBC on behalf of Trennd, in part because the only new thing which the credit facility extended to Cal-Gas was an operating line of credit which it ultimately made little use of. Consequently, the Interpretation Bulletin IT-445, which states that “[i]nterest expense on money borrowed to be loaned at a reasonable rate of interest or to honour a guarantee which had been ‘given for adequate consideration’ is generally deductible”, was not applicable to this case.

Second, the Trial Judge relied on Bronfman Trust, supra,[3] for the proposition that even if the original guarantee was for the purpose of earning or producing income, tracing to such an indirect purpose well exceeded the narrow scope of the exception set out in subparagraph 20(1)(c)(i). As a result, the Trial Judge agreed with the Minister and with the Tax Court Judge that the true purpose of the $1.7 million loan was to help out Cal-Gas’ ailing parent corporation, Trennd. As Cal-Gas was not in the business of giving and paying guarantees, it could not deduct interest payments on loans for this purpose.

Arguments on Appeal

Before this Court, the appellant persisted with the position which it had taken in the Trial Division, which was that the money borrowed from Wells Fargo could be traced to an eligible income earning purpose if it was traced back to the reason why the guarantee was originally given. In support, the appellant argues that the financing which it initially received from the CIBC in 1979 occurred on the understanding that a consolidated credit facility with the CIBC would follow. This credit facility, it is argued, was for the purpose of ensuring that Cal-Gas would be able to pursue the income-producing opportunity with Husky. As such, the purpose of the guarantee, at the time the guarantee was given, was to facilitate the financing arrangement which had made its participation in the Husky opportunity possible. In response to the Trial Judge’s finding that Cal-Gas was financially independent at the time the guarantee was given in 1980 and so not in need of the consolidated credit facility, the appellant makes two submissions: first, the Husky deal was still in its very early stages at that point and had not yet developed to the point where Cal-Gas was on its feet;[4] and second, the initial financing would never have been extended to Cal-Gas if the consolidated credit facility was not in the contemplation of both Cal-Gas and the CIBC at the time the leases were arranged.[5] Finally, the appellant challenges the Trial Judge’s finding that Cal-Gas received inadequate consideration for its guarantee. It suggests that the consideration it received was approximately $1.2 million in initial financing which was received in anticipation of the consolidated credit facility, and an increase in operating credit through Trennd. As such, the appellant submits that Interpretation Bulletin IT-445 ought to be applicable to this case.

The respondent argues that, in honouring its guarantee, Cal-Gas was making a payment on capital account, as Cal-Gas is not in the business of lending money. In order to bring interest payments within paragraph 20(1)(c), the taxpayer cannot rely on a “less direct eligible use”. Here, the direct use was to pay a debt owed by Trennd. This use, in and of itself, produced no income. In the alternative, it is argued that even if the Court is entitled to look at the time the appellant gave the guarantee, there was sufficient evidence of increasing profits prior to the creation of the consolidated credit facility to support the Trial Judge’s finding that Cal-Gas did not need the credit facility to engage in the Husky opportunity.[6] The respondent also urges that the Court is not required to follow the Minister’s policy as specified in Interpretation Bulletin IT-445 and, even if it were, as the Trial Judge found, there was inadequate consideration for the guarantee here as Cal-Gas had secured the bulk of its financing prior to the establishment of the credit facility.[7]

Analysis

The interest payment deduction allowed by subparagraph 20(1)(c)(i) has been strictly applied by the courts. This is so because these payments are usually made to increase the capital holdings of taxpayers. Without statutory authorization, therefore, no deduction at all would normally be permitted for these payments. However, because Canadian fiscal policy seeks to encourage the augmentation of income earning potential, certain deductions for interest are permitted in paragraph 20(1)(c).[8]

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 guarantee was originally given. The Trial Judge was correct in concluding that the loan of $1.7 million was taken in order to honour the guarantee of the appellant and was not taken or used directly for the purpose of earning income from business or property.

(i)         Preservation of income-producing assets as true purpose:

The Trial Judge was unpersuaded that the interest on the borrowed money could be brought within subparagraph 20(1)(c)(i) simply because Cal-Gas wished to preserve its income-producing assets while at the same time pay off the indebtedness of Trennd. The Trial Judge explained, consistently with the Tax Court Judge before him, as follows [at page 210]:

Although the plaintiff may have borrowed the money and paid it over to CIBC in order to prevent its business and assets from being put into receivership by the CIBC, the direct purpose of that particular borrowing was to allow its “parents” Anderson and Trennd (1979) to meet their debt obligations.

On the basis of this finding of fact, the Trial Judge rejected the appellant’s attempt to bring this case within the principle enunciated by President Thorson in Imperial Oil Ltd. v. Minister of National Revenue, [1947] Ex. C.R. 527. Here, interest on a loan used to discharge liability for a ship collision was deductible because the payments were made in relation to a risk which was foreseeable in the shipping industry and thus, as the Trial Judge summarized [at page 207], “incidental to its business from which it earned its income”.[9] The Trial Judge distinguished this case by stating that, in order to bring the Wells Fargo loan under that principle [at page 208], “there must be more to the borrowing than simply being led to the indebtedness for the purpose of paying off Anderson’s and Trennd (1979)’s debts, which were not really an incidental part of the plaintiff’s business from which it earned its income”. This finding of fact is supportable on the evidence and the Trial Judge’s conclusions of law based upon it are unimpeachable.

The Trial Judge further recognized, as the Tax Court Judge did also, that [at page 208] “the Court must have regard for what was done by the taxpayer, and not what might have been done about the putative deductions which the plaintiff now seeks to be allowed”. This reasoning is entirely consistent with Dickson C.J.’s warning in Bronfman Trust, supra, that subparagraph 20(1)(c)(i) requires courts to respond to “what the taxpayer actually did, and not what he might have done”.[10] In that case, the issue as identified by Dickson C.J. was precisely the issue which is raised by the appellant’s argument [at page 35]:

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.

In responding to this issue, Dickson C.J. observed that, although there has been a trend in tax cases “towards attempting to ascertain the true commercial and practical nature of the taxpayer’s transactions …. [t]his does not mean … 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”.[11] That observation is equally applicable here.

(ii)        Obtaining access to credit facility as true purpose:

The appellant’s attempt to bring itself within subparagraph 20(1)(c)(i) on the ground that the purpose for which the original credit facility was arranged is the real trigger for the deduction sought is also unpersuasive in fact and law.

The Trial Judge, after examining all of the documents and hearing all the oral evidence, concluded as follows [at page 207]:

The plaintiff still argues that the true purpose of the $l.7 million borrowing on a proper view of the transaction—truly the transactions—and the Court views them back to summer 1978—was to provide a credit facility for Cal-Gas. That was the (only) way in which it could have afforded to get into that profitable business at Lloydminster asserts plaintiff’s counsel. The Court does not agree with that posture in terms of times and volume of business both long preceding the credit facility designed and proposed by Wood and Anderson in early 1980 and put in place in April, 1980 by CIBC’s acceptance of their proposal, with no great variations until CIBC became restive in 198l and later.

I can see no error in this conclusion, despite the very thorough and skilful argument of Mr. O’Brien. The Trial Judge based his findings on the documentary and oral evidence before him and I can see no way to conclude that there has been a palpable and overriding error.[12]

The Trial Judge also found as a matter of law that, even if Cal-Gas had entered into the consolidated credit scheme in order to better secure its ability to capitalize on the Husky opportunity, Cal-Gas is not permitted to adopt the original purpose of the guarantee as the purpose for which the loan was sought. The basis of this legal conclusion rests on the much-cited remarks of Dickson C.J. in Bronfman Trust:[13]

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 ….

According to Chief Justice Dickson, it is also necessary to focus not on the original use of the money but its current use.[14] A taxpayer cannot continue to deduct interest payments merely because the original use was for income-producing purposes; the current use must also be aimed at earning income. The loan from Wells Fargo Bank to the taxpayer could not have been considered as one from which the taxpayer might earn profit, and, hence, any interest paid on that loan was not deductible.

Another case which supports this conclusion is Interior Breweries Ltd. v. Minister of National Revenue,[15] where Cameron J. of the Exchequer Court refused to allow the deduction of interest paid on a loan that was taken out to pay a bank loan. His Lordship explained[16] that the borrowed money was not used to earn income, but was “used entirely to pay off the bank loan”. A deduction is allowed “only if the borrowed monies themselves are used for the purpose of earning income from the business”.[17] The same comments may be made in this case where the loan money was used to honour the guarantee, not to earn income. Even if the initial trigger for the borrowing was the guarantee extended by Cal-Gas, the borrowed money was not actually used to produce income, but rather to pay off the Trennd debts to the CIBC. This is the unavoidable result of the approach which has been taken by the Supreme Court in defining the boundaries of subparagraph 20(1)(c)(i).

Professors Hogg and Magee, in their book Principles of Canadian Income Tax Law, (1995),[18] explain how the current use rule was “applied relentlessly by the Court to deny the deductibility of the interest expense where the income source that funds were borrowed to acquire had disappeared”.[19] The authors indicate that the harshness of this rule was abrogated to an extent in 1994 when section 20.1 [Income Tax Act, R.S.C., 1985 (5th Supp.), c. 1 (as enacted by S.C. 1994, c. 21, s. 13)] was enacted to permit deductibility of interest where the property purchased with the money borrowed ceases to earn income, at least as far as certain stocks and bonds are concerned. Consequently, in my view, any remedy for the appellant and others like it must come from Parliament or the Supreme Court of Canada, not this Court.[20]

(iii)       Relevance of the Interpretation Bulletin:

The Interpretation Bulletin IT-445, dated February 21, 1981, though certainly worth considering, is not of any help in this case. It reads in part as follows:

[Interpretation Bulletin IT-445] The deduction of interest on funds borrowed either to be loaned at less than a reasonable rate of interest or to honour a guarantee given for inadequate consideration in non-arms’ length circumstances.

This bulletin replaces paragraph 8 of IT-239R dated April 18, 1977. The comments in 7 to 10 below are applicable commencing with a taxpayer’s 1982 fiscal period. However, they will also be applicable to interest paid or payable relative to a 1981 fiscal period in respect of a loan made after the issue date of this bulletin.

1. This bulletin deals with the circumstances in which a taxpayer is permitted to deduct interest on borrowed funds which are either loaned at less than a reasonable rate of interest (see 6 below for the Department’s comments on reasonableness) or are used to honour a guarantee for which adequate consideration has not been received by the guarantor. The Department’s views on the deduction of an allowable capital loss resulting from either the loan or the guarantee are discussed in IT-239R2.

2. Although this bulletin refers to shareholders and corporations, these terms are interchangeable, where appropriate, with partners and partnerships where partners lend money to their partnership or guarantee the partnership’s debts.

General Position

3. Interest expense on money borrowed to be loaned at a reasonable rate of interest, or to honour a guarantee which had been given for adequate consideration, is generally deductible. However, interest expense incurred on borrowed money is generally not deductible in whole or in part when that money

(a) is loaned interest-free or at less than a reasonable rate of interest.

(b) is loaned under circumstances in which the terms of payment of that reasonable rate of interest, by the person to whom the borrowed money was loaned, is not clearly established at the time of the loan, or

(c) is not used to earn income directly by the borrower in his business or from a property acquired with that borrowed money. The fact that the borrower may earn income indirectly, for example through increased dividends from a corporation to whom an interest-free loan has been made, is not sufficient cause to permit the borrower to deduct interest on his liability. (However, see exceptions discussed in 7 to 10 below.) More than just back-to-back loan situations are contemplated in this paragraph.

4. If the corporation to which money has been loaned ceases operations and there are not reasonable prospects of the corporation providing income to the shareholder, the deduction of interest on the shareholder’s liability is no longer permitted. Since the corporation has ceased operating, it cannot be argued that the money loaned thereto is being used in an income-earning operation. In any given taxation year, it is the use to which the borrowed money is being put which must be taken into account, not the use to which those funds were originally put.

First, the Bulletin does not apply because the Trial Judge correctly found that there was inadequate consideration received in return for the loan as required by section l. Second, it does not meet the criterion set out in the last sentence of section 4, because the use of the money was not the use to which the funds were originally put.

In affirming the decision of the Trial Judge, it should not be taken that this Court agrees with all that was written by him including his sometimes rather colourful remarks. In particular, neither counsel nor the Court could see any justification for his use of the word “concocted” in relation to an exhibit prepared for purposes of the trial.[21]

Lastly, I am unable to see how the decision of Tonn v. Canada[22] can be of any assistance to the appellant in this case, which deals with a very different set of circumstances.

The appeal should be dismissed with costs.

Strayer J.A.: I agree.

* * *

The following are the reasons for judgment rendered in English by

Robertson J.A. (concurring):

I.          INTRODUCTION

Following a corporate reorganization, “Cal-Gas” was one of several companies under the umbrella of its parent, “Trennd”. In pursuing that reorganization, Trennd and its sole shareholder “Anderson” sought out and obtained a $7.4 million credit facility with the “Bank of Commerce”. Of that amount, $3.3 million was made available as an operating line of credit to which Cal-Gas and its related corporations would have access through Trennd, the group’s banker. The remainder of the credit facility represented the pre-existing indebtedness of the Trennd companies to the Bank, including $1.3 million attributable to Cal-Gas. As a condition of granting the credit facility, the Bank required guarantees from Cal-Gas, Anderson and the other related companies. Two years later the Bank demanded repayment and called upon Cal-Gas, the only profitable arm of the Trennd group, to honour its contract of guarantee. By that date Cal-Gas had repaid all monies owing to Trennd under the credit facility. Cal-Gas complied with the Bank’s demand by borrowing $1.7 million of the $2.2 million needed to discharge its liability. Anderson contributed the remaining $500,000.

Cal-Gas sought to deduct the interest payments pursuant to subparagraph 20(1)(c)(i) of the Income Tax Act. That provision states that amounts paid pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning non-exempt income from a business or property are deductible from income. By reassessment, the Minister of National Revenue denied the deduction. Cal-Gas’ appeal to the Tax Court of Canada was dismissed as was its de novo appeal to the Trial Division of this Court: see 74712 Alberta Ltd. v. M.N.R., [1990] 2 C.T.C. 2001 (T.C.C.) and [1994] 2 C.T.C. 191 (F.C.T.D.), respectively.

I have had the advantage of reading the draft reasons of my colleague, Mr. Justice Linden. I share the respectful view that interest payments on the $1.7 million bank loan are not deductible from income. Where my opinion differs is in the legal reasoning offered in support of that legal conclusion. My reasons rest on an extensive analysis of the Supreme Court of Canada’s seminal decision in Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32, and its implications. As one Tax Court Judge has rightly noted, that decision is now cited in support of many propositions: see Mark Resources Inc. v. Canada, [1993] 2 C.T.C. 2259 (T.C.C.), at page 2269, Bowman T.C.C.J. (appeal to F.C.A. withdrawn).

II.         RELEVANT LEGISLATION

The statutory provisions relevant to this appeal read as follows:

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),

…

or a reasonable amount in respect thereof, whichever is the lesser;

III.        BRONFMAN REVISITED

The trustees of the Bronfman Trust elected to make a capital allocation of $2.5 million to a beneficiary. Rather than liquidating any of the Trust’s $70 million in capital assets, the trustees considered it advantageous to borrow the needed funds. Three years later the loan was repaid after some of the Trust’s assets were sold. In the interim the Trust sought to deduct the interest payments in each of the three years the loan remained outstanding. Those amounts greatly exceeded the amount saved by not liquidating some of the Trust’s capital assets. The Supreme Court began its analysis by reaffirming the principle established in Canada Safeway Limited v. The Minister of National Revenue, [1957] S.C.R. 717, at pages 722-723 and 727. In that case it was held that in the absence of a statutory provision authorizing the deduction of interest in respect of borrowed funds, such payments are deemed an outlay “on account of capital” and, therefore, not deductible from income pursuant to paragraph 18(1)(b) of the Act [then s. 12(1)(b) of The Income Tax Act, S.C. 1948, c. 52]. The decision in Canada Safeway is also important because it laid the analytical foundation for what would become the “direct-use” rule articulated in Bronfman. For that reason alone it is worth revisiting the facts and legal reasoning of the former case.

In Canada Safeway, the corporate taxpayer (Safeway) operated a chain of grocery stores and had borrowed money to acquire the shares of a distributor of grocery products with which Safeway had substantial business dealings. The taxpayer sought to deduct the interest payments on the basis that the ownership of the shares increased its income-earning capacity by enabling it to receive, for example, preferential treatment from the distributor and a competitive advantage over other grocery store chains. The taxpayer did not argue, nor could it argue, that the shares were purchased for the purpose of gaining taxable income. At that time, intercorporate dividends were classified as tax-exempt income.

A majority of the Supreme Court held that the taxpayer was not entitled to deduct the interest payments. For the taxation years in question, and pursuant to subsection 6(5) of the 1939 Tax Act [Income War Tax Act, R.S.C. 1927, c. 97 (as enacted by S.C. 1939, c. 46, s. 8)], expenses incurred to earn tax-exempt income were not deductible. The money Safeway had borrowed was not used in the taxpayer’s own business to earn taxable income but rather, was used to earn tax-exempt income in the form of dividends received from the distributor. As to the collateral benefits enjoyed by the taxpayer, it was found that they were “indirect and remote” effects (Rand J., at page 727): see also Interior Breweries Ltd. v. Minister of National Revenue, [1995] Ex. C.R. 165, where interest was held to be non-deductible in circumstances where the taxpayer borrowed monies to repay a loan used to purchase dividend-producing shares.

I note that the Supreme Court recently acknowledged the view held by some commentators that Canada Safeway was “wrongly” decided: see Tennant v. M.N.R. , [1996] 1 S.C.R. 3, at pages 316-317, Iacobucci J. I presume that that acknowledgment stems from and is limited to the holding in Canada Safeway that interest is necessarily an outlay on capital: see P. W. Hogg and J. E. Magee, Principles of Canadian Income Tax Law (Carswell, 1995), at page 221, note 36; and B. J. Arnold, “Is Interest a Capital Expense?” (1992), 40 Can. Tax J. 533. If I am mistaken on this point then obviously the Supreme Court would have to re-evaluate Bronfman as well.

For the sake of completeness, I note also that the rule in Emerson (R.I.) v. The Queen, [1986] 1 C.T.C. 422 (F.C.A.), leave to appeal denied [1986] 1 S.C.R. viii, appears to have been abrogated by a 1994 amendment to the Act: see section 20.1. The rule in Emerson denies the deduction of a continuing interest expense once the source of income that was acquired with the borrowed monies ceases to exist. The rule itself has always attracted severe criticism: see G. D. Dixon and B. J. Arnold, “Rubbing Salt into the Wound: The Denial of the Interest Deduction After the Loss of a Source of Income” (1991), 39 Can. Tax J. 1473.

A)        The Direct-Use Rule

For purposes of determining the deductibility of interest payments two general rules were affirmed in Bronfman: the “direct-use” and “current-use” rules. The ambit of the former rule can be traced to three passages found within the reasons for judgment (at pages 45-46 and 53-54):

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, 59 D.T.C. 247 (T.A.B.).

…

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.

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”.

The above extracts render it clear that the direct-use rule has two prongs. First, it is necessary to trace the borrowed funds to an eligible use, that is, to an income-producing source, whether it be from a business or property. Second, there must be a sufficiently direct connection between the use of the borrowed funds and the source of income. Thus, even in cases where the borrowed funds are used for a purpose which has the indirect effect of enhancing the taxpayer’s income-earning capacity, the interest payments remain non-deductible. The income-earning purpose is simply too remote.

The classic example of the direct-use rule involves a taxpayer who borrows for the purpose of purchasing a personal residence. In such cases the borrowed funds can be traced immediately to the purchase of an asset. That asset, however, is incapable of generating income for the taxpayer so long as the property is occupied as a personal residence. Thus, it cannot be said that the borrowed funds were used for the purpose of gaining or producing income within the meaning of paragraph 20(1)(c) of the Act. In Bronfman, Dickson C.J. describes the legal result in terms of a “direct ineligible use of borrowed money” or an “ineligible direct use”. Even if the borrowed money has the effect of enabling the taxpayer to retain income-earning investments, interest payments remain non-deductible. This is described as an “indirect eligible use of funds”. Interest payments fall outside the direct-use rule because the borrowed funds are used for the indirect purpose of enhancing the taxpayer’s earning capacity, that is to say, a remote purpose.

At this point I wish to make three observations which will take on greater significance later in these reasons. First, the direct-use rule follows the principle set out in paragraph 18(1)(a) of the Act that expenses must be related to a source of income. Thus, for example, interest payments tied to consumption expenditures are not deductible because they yield no taxable income from a business or property.

Second, as a matter of tax planning, transactions should be structured such that the taxpayer borrows funds for business and investment purposes. For consumption purchases a taxpayer should use savings. As Professor Krishna has suggested: “Borrow for business and use savings for pleasure” (V. Krishna, The Fundamentals of Canadian Income Tax , 5th ed. (Toronto: Carswell, 1995), at page 714).

Third, I see nothing in the jurisprudence, in particular the reasons of Bronfman, which requires a subjective appreciation of the motives or intent underlying the taxpayer’s decision to borrow funds: see also Symes v. Canada, [1993] 4 S.C.R. 695, at page 736 to the same effect in the context of paragraph 18(1)(a) of the Act. The words “use” and “purpose” are used in paragraph 20(1)(c) in an objective not subjective sense. It is important to recognize that terms such as “motive, intent, reason, purpose, object and effect” can be applied or interpreted differently, depending on the statutory context in which they are invoked: see generally Canada v. Placer Dome Inc., [1997] 1 F.C. 780(C.A.) and J. F. Avery Jones, “Nothing Either Good or Bad, but Thinking Makes It So—The Mental Element in Anti-Avoidance Legislation” (1983), British Tax Review 9.

B)        The Current-Use Rule

Bronfman also confirmed the validity of the current-use rule which provides that it is the current and not original use of borrowed funds that is relevant in assessing the deductibility of interest payments. Thus, for example, a taxpayer who first borrows money for a direct ineligible use (such as to purchase a residence), is unable to claim a deduction with respect to interest payments. Should, however, the ineligible use become an eligible one (assume the property is now rented), interest payments become deductible under subparagraph 20(1)(c)(i) of the Act. The converse is also true. The full impact of the current-use rule was canvassed most recently by the Supreme Court in Tennant v. M.N.R., supra.

The current-use rule is premised on the legal understanding that it is the purpose underlying the use of the borrowed funds, and not the purpose for which they were borrowed, which is determinative. In many cases the purpose is the same for both the use and borrowing. In Bronfman, Dickson C.J. recognized the validity of that distinction (at page 46) and relied on the seminal decision of the Tax Appeal Board in Auld v. Minister of National Revenue (1962), 62 DTC 27 (T.A.B.). It is worthwhile reproducing the relevant passage from the Board’s decision (at page 30):

In my opinion, it is not the purpose underlying the borrowing of the money which is relevant; it is the purpose underlying the use of the borrowed money. It will probably happen in most situations that the purpose is the same for both the borrowing and the use but where the purposes are different, it is the latter one which is decisive. An example makes the distinction apparent. A may borrow $10,000 to assist him in the purchase of a residence in which he intends to live. However, after the borrowing, he decides not to purchase the house and puts the $10,000 in his unincorporated business, where a business use is made of it. In my opinion, the interest paid on the $10,000 clearly is deductible under section 11(1)(c) as the purpose for which it was used, was to earn income. Although the purpose for which it was borrowed had nothing to do with the earning of income, this is irrelevant. [Underlining added.]

As was true in Bronfman, the current-use rule has no application to the facts of the case at bar. In Bronfman, the immediate or original use and purpose of the borrowed funds was to make a capital allocation to the beneficiary. Consequently, the Trust received no enduring asset in return. Once paid over to the beneficiary, the borrowed funds were spent and not available to the Trust for a subsequent or current use, whether eligible or ineligible: see Bronfman, at page 47. Similarly, in the present case the borrowed funds were dissipated once they were paid to the Bank. In granting and honouring the guarantee, Cal-Gas received no saleable or enduring asset in return. Hence, the borrowed funds could never be traced to a subsequent or current use.

C)        The Impact of Bronfman and Administrative Practices

Returning to the direct-use rule, Dickson C.J. concluded in Bronfman that the immediate and direct use of the funds was for the purpose of making a capital allocation and not for earning income. This constituted a direct ineligible use of borrowed funds. However, the fact that the borrowing allowed the Trust to retain income-earning investments amounted to an indirect eligible use. Having regard to the principles of stare decisis, it cannot be said that the ratio decidendi of Bronfman is limited to the simple proposition that interest payments on borrowed funds used for the purpose of making a capital allocation to a beneficiary under a trust are not deductible from income pursuant to subparagraph 20(1)(c)(i) of the Act. Certainly that aspect of Bronfman has never been doubted or even criticized. But Bronfman also stands for a much broader rule of law: interest payments on funds borrowed for a direct ineligible use are not deductible from income.

Due to the breadth of the direct-use rule, the legal community and the Minister were taken off guard when Bronfman was released. For tax planners the decision raised questions about the ambit of the direct-use rule in numerous commercial settings. As to the perceived ramifications of Bronfman, see R. Couzin et al., “Tax Treatment of Interest: Bronfman Trust and the June 2, 1987 Release” in Corporate Management Tax Conference (Canadian Tax Foundation, 1987) at page 10:1.

Seeking to clarify the possible application of the reasoning in Bronfman to other apparently analogous situations, on 2 June 1987 the departments of Finance and National Revenue issued a joint press release accompanied by a notice of ways and means motion to amend the Income Tax Act. As stated in that release, the Minister was prepared to continue with the administrative practices set out in other interpretation bulletins. It is my understanding that the interpretation bulletins and administrative practices relating to the deductibility of interest continue to be applied today even though the Act has not been amended in this respect, save for the addition of section 20.1. Whether such practices accord with the law as stated in Bronfman was a matter raised by the Trial Judge below: “the superior Courts are the authentic and authoritative interpreters of the law, not the Minister” (supra, at page 208).

The Minister continues to adhere to one administrative practice which presents a direct challenge to the ruling in Bronfman. Before the Trial Judge, the Minister conceded that in accordance with Interpretation Bulletin No. IT-445, dated 21 February 1981, interest on borrowed funds used to honour a guarantee is deductible provided the taxpayer received adequate consideration at the time the guarantee was extended. This concession gives rise to two preliminary observations. First, Interpretation Bulletin No. IT-445 also provides that in defined instances interest is deductible even if the guarantee is given for inadequate consideration. I note that the facts of this case do not come within the criteria identified. Second, I am cognizant of the fact that Minister of National Revenue v. Steer, [1967] S.C.R. 34 is not supportive of the administrative practice in question. On the other hand, the brevity of the reasons for judgment (delivered from the bench), combined with the fact that Steer was decided over 20 years prior to Bronfman are factors which suggest that that case should be approached cautiously.

As will be explained below, there can be no doubt that interest payments on funds borrowed for the purpose of honouring a guarantee fall within the direct ineligible use category. (I state this as a general proposition.) If that is so then it is open to ask whether there is any legal basis for the administrative practice set out in IT-445 or for that matter those set out in other relevant interpretation bulletins, which represent a challenge to the direct-use rule established in Bronfman. On the present appeal, the Minister pointed out that the courts are not bound by administrative policies such as those outlined in IT-445 and must apply the law to the facts. At first blush that submission seems incompatible with the concession made at trial. I shall treat that concession as an invitation to determine whether there is a legal foundation for allowing exceptions to the direct-use rule, including that based on guarantees granted for adequate consideration. I do not hesitate to pursue this line of analysis for if there is no legal basis for recognizing exceptions to the rule then I share the Trial Judge’s concern that the Minister may be acting inconsistently with the rule of law.

D)        The Exceptional Circumstances Qualification

The precedential value of Bronfman does not end with the direct- and current-use rules. Dickson C.J. went on to consider the possibility of granting relief from the strictures of the direct-use rule in exceptional circumstances. On the facts of that case he was not prepared to permit the Trust to deduct the interest payments in question. At page 54 of his reasons the former Chief Justice raised the matter:

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.

It would be misleading to suggest that the above passage constitutes an unqualified acceptance of a discrete category of exceptions to the direct-use rule. The phrase “[e]ven if there are exceptional circumstances” suggests that the former Chief Justice was reluctant to encourage the recognition of an exceptional category which could be used to undermine the direct-use rule. Nonetheless, I am convinced that it is proper to infer from the above passage that in certain circumstances interest payments may be deducted even though they are tied to a direct ineligible use of borrowed funds. In support of that conclusion I offer four reasons. Summarily stated, they are as follows.

First, the exceptional category accords with the object and purpose of subparagraph 20(1)(c)(i). Second, recognition of the exceptional category does not negate the policy objective underlying the existence of the direct-use rule. Third, the Supreme Court in Bronfman did not expressly overrule Trans-Prairie Pipelines, Ltd. v. M.N.R., [1970] C.T.C. 537 (Ex. Ct.). In that case it was held that the taxpayer could deduct from income interest payments on funds borrowed for what may be regarded as an indirect eligible use. Fourth, the exceptional category accords with the directive found in Bronfman that transactions be viewed with an eye to “commercial realities”. I turn now to the task of dealing with each of these rationales more fully.

Today, it is trite to acknowledge that Parliament enacted subparagraph 20(1)(c)(i) of the Act to lessen the impact of paragraph 18(1)(b) and encourage the accumulation of capital used in the production of taxable income. In Tennant v. M.N.R., supra, at pages 320-321, this Court was faulted for failing to adopt an approach which furthers the purpose of subparagraph 20(1)(c)(i). The exceptional circumstances qualification promotes that aim and need not undermine the true policy objective underlying the direct-use rule. This is so provided the exception is carefully drawn so as not to allow it to overtake the rule. This leads to consideration of the true policy rationale underscoring the direct-use rule.

One cannot escape the fact that in Bronfman Dickson C.J. expressed repeated concern over the possibility of relaxing the strictures of the direct-use rule so as to allow the deduction of interest payments in regard to what I would label as ineligible personal uses, including the purchase of vacation homes and life insurance policies. Much of the jurisprudence cited in Bronfman, and that is litigated today, involves the purchase of residential properties which can be used for either personal or rental purposes. Inevitably, the issue revolves around the deductibility of mortgage interest payments: e.g., M.N.R. v. Attaie, [1990] 3 F.C. 325 (C.A.). But the cases are not confined to the purchase of personal residences. For example, before the Tax Review Board in Bronfman the Minister relied on Sternthal, J v The Queen, [1974] CTC 851 (F.C.T.D.) to counter the Trans-Prairie decision. In Sternthal the taxpayer, with assets greatly exceeding his liabilities, borrowed $250,000. On the same day he extended to his children interest-free loans totalling $280,000. Understandably, interest payments were held not to be deductible.

Against this background, it is understandable why the Supreme Court would not want to encourage deviation from the direct-use rule. To allow taxpayers to deduct interest payments from income on the basis of an indirect eligible use (the preservation of income-producing assets), when the direct use serves no economic purpose, would provide a windfall to affluent Canadians and be unfair to less wealthy taxpayers. This tax equity argument is expressly pursued in Bronfman. The blunt observations of Dickson C.J. on this point are more often than not overlooked and yet, in my view, they represent the true policy rationale underlying that decision (at pages 48-49):

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.

Having regard to the policy rationale articulated above, it seems to me that in cases where the borrowed funds cannot be traced to an ineligible use of the kind witnessed in Bronfman or Canada Safeway there is some room for the application of the exceptional circumstances qualification. In support of that proposition I turn to the Trans-Prairie decision.

In Trans-Prairie, the corporate taxpayer wanted to raise capital by way of a bond issue for purposes of expanding its business operations. However, because of sinking fund requirements, the taxpayer could not float a bond issue unless it first redeemed its preferred shares. The taxpayer borrowed $700,000 and used $400,000 to redeem the preferred shares. The remaining $300,000 was used in the expansion of the business. The Minister disallowed the deduction of four-sevenths of the amount of interest on the loan on the ground that $400,000 of the $700,000 was not used for the purpose of earning income from a business. President Jackett, as he then was, allowed the taxpayer’s appeal and held that interest payments on the entire $700,000 were deductible. He viewed the borrowed funds as “fill[ing] the hole left by redemption” (at page 541).

The legal reasoning and result reached in Trans-Prairie fully support the understanding that interest payments may be deductible from income even though that case involved what Dickson C.J. would appear to have characterized as an indirect eligible use of borrowed funds. Understandably, the taxpayer in Bronfman relied on the Trans-Prairie decision. Unfortunately, and with great respect, Chief Justice Dickson’s treatment of the latter case is ambivalent. There are two passages in Bronfman which dwell on the Trans-Prairie decision. Both are worth reproducing (at pages 52 and 54):

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.

…

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. [Underlining added.]

With respect to the first quoted passage, it is apparent that the former Chief Justice viewed the facts in Trans-Prairie as giving rise to an indirect eligible use of borrowed funds. At least, it is generally assumed as much: see Krishna, supra, at page 714. What is not clear is whether the converse characterization (as a direct ineligible use) was based on an appreciation that the income-earning effects were simply too remote or the fact that the act of borrowing for the purpose of redeeming shares is not a transaction which by itself is capable of generating income or a profit. (This ambiguity raises the question of whether a borrowing transaction can give rise to an expected loss and still qualify as an eligible use. I deal with that question later on in these reasons).

With respect to the second of the above passages, I draw two conclusions. The first is obvious. Bronfman did not expressly overrule Trans-Prairie. I believe that it is of some significance that the Supreme Court in Bronfman upheld the result arrived at by Pratte J.A. in the Court of Appeal. Mr. Justice Pratte did not decide that Trans-Prairie was wrongly decided. He distinguished it on the basis of the “gap theory” outlined above. The second and related conclusion is that Chief Justice Dickson’s observations imply that the outcome in Trans-Prairie could be sustained on the basis of a reasonable expectation that the borrowing transaction would give rise to a profit. That fact was absent in Bronfman of which more will be said below.

The only other case, of which I am aware, which touches on Bronfman’s assessment of the validity of Trans-Prairie is M.N.R. v. Attaie, supra, at page 334. There, the Court observed that in Bronfman, Dickson C.J. upheld the reasoning in Trans-Prairie. The Court went on to hold that as the borrowed funds were used to finance the taxpayer’s personal residence, he had failed to meet the special circumstances outlined in Trans-Prairie.

In my opinion, had the former Chief Justice been of the view that Trans-Prairie was in conflict with the decision reached in Bronfman, that is to say wrongly decided, he would have said as much. I appreciate that for purposes of deciding this appeal it is unnecessary to rule on the correctness of Trans-Prairie. It is sufficient to hold that the Supreme Court’s treatment of that case supports the acceptance of a discrete category of exceptions to the general rule on deductibility of interest.

Finally, I turn to the now seminal “commercial realities” passages in Bronfman. They reflect, I believe, Chief Justice Dickson’s willingness to admit of exceptions to the direct-use rule (at pages 52-53):

I acknowledge, however, that just as there has been a recent trend away from strict construction of taxation statutes … 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 …. [Citations omitted.]

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.

Few tax cases are argued in this Court which do not begin with a reminder that the Court must have regard to the true commercial and practical nature of the taxpayer’s transactions. All must be assessed with an eye to commercial and economic realities. What is often overlooked are the observations of Dickson C.J. found within the second passage reproduced above. Therein is found his apparent concern over the inequity of tax liability being dependent upon taxpayer sophistication and the ability to manipulate events to achieve “a patina of compliance” with the Act.

To tax practitioners the commercial realities exhortation may be a polite way of cautioning judges who may be “at sea” when dealing with complex commercial transactions. To me the exhortation also serves as a reminder that the interpretative process is not to be reduced to the simple and mistaken premise that the sole purpose of the Act is to raise revenue. The reality is that the Act seeks to achieve competing objectives and it is not always easy to divine an interpretation with respect to an ambiguous provision which does not unduly intrude on one objective at the expense of another.

In the present context, the commercial reality is that corporate borrowing is as integral to the income-earning process as is the provision of third-party security, granted by related corporations or shareholders to lenders. Both the giving and taking of guarantees are part of the daily income-earning process in the commercial world. The same cannot be said of a capital allocation to a beneficiary under a trust. As Judge Bowman has observed in respect of the Bronfman case: “The vague purpose of protecting assets that produced virtually no income was patently subservient to the direct and uneconomic purpose of distributing capital to a beneficiary of the trust” (Mark Resources, supra, at page 2270).

In conclusion, I am of the respectful view that the reasoning of the Supreme Court leaves open the possibility of recognizing exceptions to the direct-use rule. At the very least the law should be willing to consider the question of deductibility of interest in cases where it can be shown that the application of the direct-use rule would not serve its intended purpose. I turn now to the difficult question of what criteria are to be applied when circumscribing the boundaries of the exceptional category.

E)        The Scope of the Exceptional Circumstances Category

Having accepted that Bronfman did not preclude recognition of exceptions to the direct-use rule, under the umbrella of an exceptional circumstances category, it is still necessary to isolate the criteria to be applied when determining whether interest payments on funds borrowed for a direct ineligible use are deductible from income. In Bronfman, Dickson C.J. mentions only two requirements: that the taxpayer establish a bona fide purpose (intention) to use the funds to earn income and a reasonable expectation that the borrowing transaction would yield income in excess of the interest expense.

As a practical matter, two other obvious factors should be kept in mind when determining whether the facts of a case come within the exceptional circumstances qualification: whether the taxpayer is invoking the “preservation of income-earning assets” argument and, ultimately, whether the borrowed funds were utilized for business or economic purposes. As best I can predict, the preservation of assets argument will never carry any weight.

With respect to the bona fide requirement, it is evident that that criterion extends an invitation to the taxpayer to testify as to his or her intention to earn income. Second, it is equally obvious that the test is not a purely subjective one but rather, one which will be measured against accepted evidence and any reasonable inferences drawn therefrom. In my respectful view, however, this requirement is problematic. The inescapable inference is that the interest deduction is not available if mala fides on the part of the taxpayer can be established. To me that inference suggests confusion with the sham doctrine. I believe the source of the confusion can be traced to one of the arguments pursued by the Trust in Bronfman.

In Bronfman, the Trust argued, and the Minister conceded, that the Trust would have obtained an interest deduction if it had sold assets to make the allocation and then borrowed to purchase replacement assets. Dickson C.J. rejected this submission principally on the ground that the Trust could not ask the Supreme Court to characterize the transaction having regard to its commercial realities and, at the same time, ask that it be cast in terms of what the Trust could have done. Dickson C.J., however, also commented that had the Trust sold an asset to make the allocation and then immediately repurchased it with borrowed funds the courts might 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” (at page 55). Not surprisingly, and with great respect, commentators were quick to characterize the latter statement as obiter dictum.

The idea that structured tax avoidance transactions might run afoul of the sham doctrine is generally regarded as adding uncertainty to the law: see Krishna, supra, at pages 1373-1374 and Hogg, supra, at page 457, note 32. Based on other Supreme Court jurisprudence, it is generally accepted that that doctrine is founded on the notion of “deceit” and not on the broader ground suggested in Bronfman: see Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536. In the circumstances it is not difficult to appreciate why the bona fide requirement must be approached cautiously. More is to be gained by examining the second of the two requirements—reasonable expectation of profit.

It is apparent that the reasonable expectation requirement does not impose an evidential burden on the taxpayer to establish that income was actually generated by the use of the borrowed funds. It just happens that on the facts in Bronfman the evidence was overwhelming that there could be no “reasonable expectation” that the income yield from the Trust’s investments would exceed the interest payable on the loan. In one taxation year the interest on the loan was over $110,000 while the return on an equivalent amount of capital so preserved totalled less than $10,000. This was explained by Dickson C.J. at page 54 of his reasons:

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.

In the final analysis, Dickson C.J. concluded that the Trust was not entitled to deduct the interest payments. There was no reasonable expectation of profit and the funds were borrowed with respect to a direct ineligible use. In other words, the borrowing transaction did not satisfy the direct-use rule and there was no basis on which to invoke the exceptional circumstances qualification.

In addition to the two requirements imposed by Dickson C.J. there remains the Minister’s concession. As noted earlier, Interpretation Bulletin IT-445 provides that interest payments paid in respect of a loan, the proceeds of which are used to honour a contract of guarantee given for adequate consideration, may be deducted from income under subparagraph 20(1)(c)(i) of the Act. On reflection, it appears to me that that concession is simply another way of restating the reasonable expectation of profit requirement. A more meaningful approach may be to ask whether the guarantee represents an incidental aspect of the taxpayer’s business which does not expose the taxpayer to an unreasonable risk of loss. The following hypothetical may lack commercial sophistication, but it does illustrate my point.

Assume a manufacturer is able to effect a sale of 10 widgets on the condition that he guarantee payment of the purchase price to the purchaser’s banker. In return, the independent purchaser agrees to purchase 1000 widgets from the manufacturer over a term of 5 years without any further financial accommodation on the part of the manufacturer. One can fairly assume that a manufacturer dealing with such a purchaser is not engaged in commerce for the purpose of losing income. A reasonable entrepreneur will measure the risk of that contingent liability materializing and its costs before agreeing to provide the financial accommodation requested and fixing the sale prices of the widgets. In the event the manufacturer is called on to honour the guarantee and feels compelled to borrow the required funds then any interest payments could be deducted from income under the exceptional circumstances category. The guarantee was given in circumstances incidental to the taxpayer’s business and did not expose it to an unreasonable risk of financial loss. In short, the consideration was adequate or gave rise to a reasonable expectation of profit.

In summary, I am of the opinion that there is a legal foundation for the Minister’s concession as reflected in Interpretation Bulletin IT-445. Accordingly, interest paid on funds borrowed to honour guarantees given for adequate consideration may be deducted from income even though the use of such funds has only an indirect effect on the taxpayer’s income-earning capacity. The indirect eligible use is therefore not too remote in all instances.

IV.       ANALYSIS

Returning to the case at hand, and applying the principles stated in Bronfman, the first question to be addressed is whether the direct-use rule is satisfied. Before the Trial Judge, Cal-Gas argued that had it not honoured the guarantee the Bank would have placed Cal-Gas in receivership. In response, the Trial Judge held that Cal-Gas was obliged: “to demonstrate a bona fide, and not farfetched or impossible-of-achievement intention, on the facts, that the taxpayer borrowed the money for the purpose of earning income” (at page 209). The Trial Judge then went on to reject the receivership argument. Acknowledging that Cal-Gas may have borrowed the money and paid it to the Bank in order to avoid such a result, he held that: “the direct purpose of that particular borrowing was to allow [the] `parents’ Anderson and Trennd (1979) to meet their debt obligations” (at page 210).

While I agree with the Trial Judge that the receivership argument is not sustainable, I must respectfully disagree with his reasoning. In my opinion, it is apparent that the Trial Judge has confused the direct-use rule with the bona fide requirement discussed earlier. It is true that the Trial Judge found the only two witnesses who testified on behalf of Cal-Gas not to be credible and, therefore, there was no factual foundation for the receivership argument. But it seems to me that what the Trial Judge has done is to assess the applicability of the direct-use rule in terms of Cal-Gas’ motive in borrowing the funds; that is, to bail out Anderson and Trennd.

Pursuant to Bronfman, it is the direct income-earning use to which the borrowed funds were employed that is in issue. Thus, the reason or motive underlying Cal-Gas’ decision to borrow the funds on which interest had to be paid remains an irrelevant consideration so far as the application of the direct-use rule is concerned. Correlatively, it is irrelevant that payment on the guarantee by Cal-Gas had the effect of relieving others from their obligation under the same guarantee. These conclusions are in accord with the Minister’s submissions. No attempt was made to support this aspect of the Trial Judge’s reasoning, either in oral or written argument.

In my respectful opinion, the receivership argument must fail for the reason that it sidesteps the requirement that the borrowed funds be first traced to a direct eligible use. I take it for granted that a corporation which guarantees, for example, the personal debts of its shareholders (e.g., involving consumption expenditures) will not be entitled to deduct interest payments on borrowed funds used to honour that guarantee. This is so even if the borrowing avoided the corporation being placed in receivership. The direct-use rule makes no allowance for such kinds of financial accommodation. The short and long of it is that even if it could be said that Cal-Gas borrowed the $1.7 million for the purpose of avoiding receivership, the funds were used for an indirect eligible use—the preservation of income-earning assets.

On appeal to this Division of the Court, counsel for Cal-Gas wisely elected to adopt another legal tack. They now argue that the relevant time for assessing “eligibility of use” is at the time the guarantee was granted and not the date the funds were borrowed for the purpose of honouring the guarantee. The Minister takes the position that regardless of which date is chosen Cal-Gas is unable to satisfy the direct-use rule. According to the Minister if the proper date is the moment the guarantee was extended, Cal-Gas was not in the business of giving guarantees for profit. Therefore, it cannot be held that the guarantee was provided for the purpose of “gaining or producing income” from Cal-Gas’ business. If the proper date is deemed to be the day the funds were borrowed, the Minister maintains that the direct-use of the borrowed funds was to pay a debt owed by Trennd to the Bank, a use which in and of itself produced no income because there was no expectation of earnings arising as a result of the payment on the guarantee. In short, Cal-Gas was not in the business of paying off or lending money to third parties.

I agree with Cal-Gas’ submission, but only to the extent that more is gained by looking to the date the guarantee was extended than at the date it was honoured. I also agree with the Minister that regardless of which date is chosen Cal-Gas is unable to satisfy the direct-use rule. Finally, I agree that the fact that the honouring of a guarantee relates to the debt of a third party is of critical significance to the outcome of this appeal. However, I cannot accept the general thrust of the Minister’s position. Rather than attempting to unravel the parties’ arguments, I propose to isolate three of the threads woven throughout the fabric of the Minister’s arguments. My purpose is to lay to rest certain misconceptions which, if allowed to go unchecked, may take on a life of their own.

The first thread to be withdrawn rests in the mistaken belief that in claiming a deduction under subparagraph 20(1)(c)(i) of the Act, Cal-Gas had to be in the business of paying debts (a philanthropist of sorts) or, alternatively, in the business of giving guarantees (a bondsman of sorts). Those propositions are clearly untenable.

The second thread revolves around the mistaken belief that to qualify as a direct eligible use a taxpayer must establish that the borrowed funds were used for a purpose leading to the production of a stream of income (e.g. purchase of shares which produce dividends). In my opinion, the direct-use rule is not conditional on the requirement that there be a direct relationship between the borrowing and the production of income. I say this because the discharge of any debt or a legal obligation can never give rise directly to an expectation of earnings let alone a profit.

My thesis is a simple one. As the law presently stands, a taxpayer need not establish a causative relationship between a particular expense and a specific receipt. The expense is deductible even if it results in an expected loss. These basic principles were confirmed by the Supreme Court in Symes, supra, at page 729, citing Imperial Oil Ltd. v. Minister of National Revenue, [1947] Ex. C.R. 527. If an expense is deductible pursuant to paragraph 18(1)(a) of the Act, then it should follow that monies borrowed for the purpose of meeting that expense are deductible under subparagraph 20(1)(c)(i). This result would be unaffected by the realization that borrowed funds will be used for a purpose which of itself is not income-generating. My point is best illustrated by reference to the Imperial Oil case.

In Imperial Oil it was held that the taxpayer was entitled to deduct an amount paid as a damages settlement arising from the negligent operation of one of its ships. The Exchequer Court rejected the Minister’s argument that the expenditure had not been made for the purpose of gaining or producing income but simply to discharge a legal liability. In response, Thorson P. pointed out that that was true of every expense. He held that so long as the liability arose as an incidental part of the taxpayer’s business it was to be deemed part of the income-earning process (at pages 538-539):

Negligence on the part of the appellant’s servants in the operation of its vessels, with its consequential liability to pay damages for a collision resulting therefrom, was a normal and ordinary risk of the marine operations part of the appellant’s business and really incidental to it.

Had Imperial Oil borrowed the funds necessary to discharge its debt obligation, I take it that the Minister would have objected to the deduction of interest on the ground that the payment of a debt is a “use which in and of itself produced no income in that there was no expectation of earnings”. In my view, the Minister’s objection is not sustainable. I do recognize that there is a difference in the wording of paragraph 18(1)(a) of the Act and subparagraph 20(1)(c)(i). The former speaks of an expense incurred for the purpose of “gaining or producing” income from a business. The latter speaks of funds borrowed for the purpose of “earning” income from a business. In my view, the distinction cannot be deemed significant if only because Imperial Oil was decided at a time when the equivalent of paragraph 18(1)(a) spoke of an expense incurred for the purpose of “earning” income from a business: see paragraph 6(1)(a) of the Income War Tax Act.

The third thread of the Minister’s argument, albeit an alternative one, revolves around the mistaken belief that it is the immediate purpose underlying the use of the borrowed funds which is of relevance. I agree with the submission of Cal-Gas that one looks to purpose as of the date the guarantee is given and not the date it was paid. There can be no doubt that in the present case the immediate use of the borrowed funds was to pay a debt owing to the Bank under the guarantee. In a narrow sense it can be said that the funds were used for that purpose. But that tells us nothing with respect to whether the funds were ultimately paid for an income-earning purpose.

In Imperial Oil the Court did not limit itself to the finding that the expense was incurred for the purpose of discharging a debt obligation. That was the immediate use and purpose of the payment. The Court in that case went on to hold that the expense was incurred for the purpose of gaining income in so far as the expenditure could reasonably be considered part of the income-earning process. In a similar fashion, subparagraph 20(1)(c)(i) forces us to look beyond the immediate use and purpose of the borrowing to ask whether there is or was a direct income-earning purpose underlying the granting of the guarantee attributable to Cal-Gas. The answer to that question must be framed in the negative.

The granting of the guarantee by Cal-Gas enabled Trennd to obtain a loan and to receive proceeds which could be used by the latter with respect to its income-earning endeavours. Thus, the granting of the guarantee was intended to facilitate the income-earning capacity of the principal debtor (Trennd) and not the guarantor (Cal-Gas). The funds borrowed by Cal-Gas were used to repay a loan granted to Trennd, the proceeds of which were used for purposes it deemed appropriate. In accordance with Bronfman it must be held that the funds borrowed by Cal-Gas were applied to a direct ineligible use. In summary, Cal-Gas’ debt obligation was its debt under the guarantee. It was not a debt in respect of an advance made to Cal-Gas for its own direct income-earning purposes: see The Commissioners of Inland Revenue v. Holder (Sir H. C., Bart) and Holder (J. A.) (1932), 16 T.C. 540 (H.L.), at page 564, Viscount Dunedin.

It should come as no surprise that the jurisprudence establishes, at least as a general proposition, that interest payments made in respect of a loan incurred for the purpose of satisfying a guarantee are not deductible from income. Though there is unanimity on this point the reasoning varies: see McLaws v. M.N.R., [1974] S.C.R. 887; Minister of National Revenue v. Steer, supra; Bowater Canadian Ltd. v. The Queen, [1987] 2 C.T.C. 47 (F.C.A.); and Canada v. MerBan Capital Corp., [1989] 2 C.T.C. 246 (F.C.A.).

At the same time, I am prepared to accept that in certain instances funds borrowed for the purpose of satisfying the debt of a third party may not offend the direct-use rule. There may be cases where a taxpayer is able to establish that he or she had access to and did actually receive proceeds of the loan guaranteed. In such instances the borrowing is directly related to the income-earning capacity of the guarantor.

For example, in the present case Cal-Gas had access to the credit facility made available by the Bank and did make use of it through Trennd, the group’s banker. Also, the initial credit facility represented $1.3 million of Cal-Gas’ pre-existing indebtedness to the Bank. Had Cal-Gas been able to establish that all or a portion of the $1.7 million it was required to pay on the guarantee related to its own indebtedness, and not that of Trennd or the related companies, then I can see no legal objection to allowing interest payments to be deducted under subparagraph 20(1)(c)(i) of the Act. In effect the debt being guaranteed would be that of Cal-Gas and the direct-use rule would undoubtedly be satisfied. On the facts of this case, however, Cal-Gas had repaid all of the monies which it owed Trennd by the time the Bank demanded payment under the guarantee.

I find support for the above qualification in McLaws v. M.N.R., supra, at pages 894-895, which anticipated the possibility of the guarantor having access to the proceeds of the loan being guaranteed. The right to deduct interest payments must be limited, of course, to that portion which can be traced directly to the indebtedness incurred by the guarantor in the course of earning income from a business or property, and which remains outstanding at the time the guarantee is called. The fact that only a portion of the interest payments may be deducted under this exception is anticipated by subparagraph 20(1)(c)(i) of the Act. That provision provides that the taxpayer may deduct such “amounts as are wholly applicable … or such part … as may reasonably be regarded as applicable thereto”. Finally, I must point out the caution given in Bronfman (at pages 45-46) that one who “commingles” funds used for a variety of purposes only some of which are eligible may be unable to claim the interest deduction.

In my opinion, it is clear in law that Cal-Gas borrowed the funds for a direct ineligible use. Therefore, the interest payments in question are not deductible from income unless the exceptional circumstances qualification articulated in Bronfman is applicable. I note that the Tax Court Judge did make a passing reference to the question of whether the facts of the present case constituted exceptional circumstances. He concluded otherwise on the ground that the borrowed funds were used to pay off the debt owed by Trennd (at pages 2004-2005). I note also that the Trial Judge made the same passing reference but was likewise not convinced of the existence of exceptional circumstances (at pages 208-209). I turn now to the issue of whether the guarantee in question was given for adequate consideration.

Traditionally, the law is only concerned with the sufficiency of consideration and not its adequacy. This case is but one exception. Counsel for Cal-Gas submitted that the consideration obtained by that company at the time it granted the guarantee was adequate both in a legal sense (present consideration in support of a contractual obligation as between Cal-Gas and the Bank) and from a business sense (as between Cal-Gas and Trennd). In return for its guarantee, Cal-Gas received a promissory note from Trennd, future access to the $3.3 million credit facility and the assumption by Trennd of Cal-Gas’ $1.3 million pre-existing indebtedness to the Bank. On the other side of the balance sheet are found Cal-Gas’ obligation to repay the latter amount and any other funds it borrowed from Trennd under the credit facility. In addition, Cal-Gas assumed a contingent liability of $7.4 million not knowing whether any of that amount would be attributable to its own indebtedness to Trennd.

Like the Trial Judge, I am of the view that what Cal-Gas received from Trennd in return for the granting of the guarantee is inadequate (supra, at pages 204 and 209). Admittedly, what constitutes adequate consideration is, in the absence of guiding criteria, a matter of subjective appreciation. In my opinion, the adequacy issue must be approached, initially, in terms of whether two reasonable and unrelated business entities would have agreed to contractual terms such as were agreed to in the present case. Were it not for the fact that Cal-Gas and Trennd are related companies, I doubt that Cal-Gas would have granted the guarantee on the basis of what it received and having regard to the potential liability that it had assumed.

In my opinion, Cal-Gas has failed to establish that the benefits or profits to be derived from the availability of the credit facility outweighed the potential risk and magnitude of loss arising from the granting of the guarantee. In the language of Imperial Oil, the risk of loss assumed by Cal-Gas could not reasonably be considered to be normal. Certainly, my hypothetical widget manufacturer would not have been prepared to act as did Cal-Gas. When a taxpayer guarantees a specific loan granted to another, it should not be too difficult to determine whether there is a reasonable correlation between the chance of gain and loss. Like the widget manufacturer, a guarantor in this situation would normally assess the risk for himself or herself in being a part of the loan transaction. Ordinarily no guarantee would be forthcoming unless the guarantor was provided with sufficient incentive in the form of adequate consideration for assuming the risk of default on the loan. Evidence of accepted commercial practice may be the most expeditious means of establishing that a guarantee was given for adequate consideration.

Arguably, similar reasoning is applicable in cases involving certain related parties, such as where a parent company responds to a lender’s call to guarantee the debts of that parent’s subsidiaries. Although provision of the guarantee is not risk-free in this instance, such a guarantee might not entail extraordinary risk for a parent corporation. The latter might reasonably expect to profit from the loan transaction and any risk assumed by the parent might be shown to be within acceptable bounds set by commercial realities. However, the taxpayer’s position becomes tenuous when as a subsidiary it guarantees the debts of its parent and other sibling corporations. Any income-earning purpose attributable to the granting of the guarantee in this instance is, in the absence of persuasive evidence to the contrary, simply too “remote” as that term is understood in tax law. This leads me to the final and pivotal issue pursued before the Trial Judge and this Division of the Court.

Based on the Trial Judge’s reasons it appears that Cal-Gas advanced what I shall label as the “business-necessity” argument. Pursuant to that argument Cal-Gas attempted to establish that prior to Trennd obtaining the credit facility the former was financially unstable, but had recently procured a lucrative contract with Husky Oil. In order to take advantage of that contract Cal-Gas needed access to permanent financing, rather than relying on a related company, “Allied”, to act as guarantor for its loans. Without the credit facility and the corporate reorganization Cal-Gas maintained that it would be unable to exploit the Husky contract. As is apparent, the business-necessity argument is tantamount to a plea to have regard to commercial realities.

The Trial Judge rejected the above argument after concluding that the two witnesses who testified on behalf of Cal-Gas were not credible. In rejecting their evidence the Trial Judge went on to describe a document which had been prepared by Cal-Gas’ advisers as having been [at page 194] “concocted” for the litigation. Counsel for both parties at trial did not appear as counsel on appeal. I hasten to add that a significant portion of the day allotted to oral argument was spent on the adverse findings of credibility.

Counsel for Cal-Gas on appeal, Mr. O’Brien and Mr. Meghji, acknowledged readily that findings of fact based on the credibility of witnesses cannot be interfered with unless it is shown that there is a “palpable and overriding error”. In this case, however, counsel are at a loss to understand how the Trial Judge could, in rendering judgment fourteen months after the trial date, see fit to question the veracity of witnesses when no issue of credibility was raised during the one-day trial. Counsel also took exception to what they termed the “gratuitous” remarks of the Trial Judge which, in their view, were “without foundation” and a “slur” on counsel appearing at trial for Cal-Gas: see appellant’s memorandum of fact and law, at paragraph 56.

In response, Mr. Curley and Ms. Nohorniak, counsel for the Minister, quite properly relied on the jurisprudence which limits interference by appellate courts on matters involving findings of fact and credibility. That jurisprudence commences with the Supreme Court’s decision in Stein et al. v. The Ship “Kathy K” et al., [1976] 2 S.C.R. 802, and ends with its most recent pronouncement in Schwartz v. Canada, [1996] 1 S.C.R. 254, at page 281.

As to the adverse findings of credibility, counsel for the Minister attempted to show that the changing nature of the legal arguments advanced by Cal-Gas may have planted the seed of doubt in the Trial Judge’s mind. In any event, they maintain that there is no legal basis on which this Court is entitled to interfere with the Trial Judge’s findings of fact. On the other hand, counsel for the Minister conceded readily that the Trial Judge was clearly in error in concluding that the document in question was concocted. Counsel went so far as to explain in detail the error of the Trial Judge in misconstruing the origins of certain financial information set out in that document. Notwithstanding that concession, the Minister maintains there is no basis for interfering with the Trial Judge’s findings of fact.

I expressly adopt the Minister’s concession that the document in question was not concocted. However, I am not persuaded that the learned Trial Judge erred in rejecting the business-necessity argument. Even if I were prepared to intervene, which I am not, I could not declare on a balance of probabilities, that the corporate reorganization and the establishment of the credit facility were effected for the purpose of permitting Cal-Gas to exploit the Husky Oil contract. Hindsight suggests that the best evidence of business necessity will come from the officers of the lending institution which extracted the guarantee in the first instance.

In closing, I wish to acknowledge Cal-Gas’ argument based on the insightful decision of this Court in Tonn v. Canada, [1996] 2 F.C. 73 (C.A.). In light of the foregoing analysis it must be obvious that I do not view Tonn as relevant to the issues at hand. For all these reasons, it follows that the appeal should be dismissed with costs.

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