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Bronfmans Attempt to Obtain Tax Credits Illegally
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Her Majesty The Queen (Appellant) v. Phyllis Barbara Bronfman Trust (Respondent)

87 DTC 5059

Supreme Court of Canada

January 29, 1987

(Court File No. 17811.)

 

   The Chief Justice (Beetz, McIntyre, Lamer, Wilson and La Forest, JJ. concurring): In computing income for a taxation year, a taxpayer may deduct interest paid on borrowed money 'used for the purpose of earning income from a business or property'. In the present appeal,

the trustees of a Trust elected to make discretionary capital allocations to Phyllis Barbara Bronfman in 1969 and 1970. Instead of liquidating capital assets to make the allocations, the trustees considered it advantageous to retain the Trust investments temporarily and finance the allocations by borrowing funds from a bank.

   The issue is whether the interest paid to the bank by the Trust on the borrowings is deductible for tax purposes; more particularly, is an interest deduction only available where the loan is used directly to produce income or is a deduction also available when, although its direct use may not produce income, the loan can be seen as preserving income-producing assets which might otherwise have been liquidated. A subordinate issue is whether the answer to this question depends upon the status of the taxpayer as a corporation, a trust, or a natural person.

I

FACTS

   By means of a Deed of Donation registered in Montreal on May 7, 1942 a Trust was established by the late Samuel Bronfman in favour of his daughter, Phyllis Barbara Bronfman ('the beneficiary'or, under Quebec law, 'the Institute') and her children. Under the terms of the Deed, the beneficiary has the right to receive 50% of the revenue from the trust property. In addition, the trustees 'in their sole and unrestricted discretion' are empowered to make an allocation to the beneficiary from the capital of the Trust if they consider it 'desirable for any purpose of any nature whatsoever'. The beneficiary has no children and in the event she dies without issue, the residue of the Trust accrues for the benefit of her brothers and sisters.

   The assets of the Trust consist of a portfolio of securities having a cost base of more than $15,000,000. By the end of 1969 Trust assets had a market value of about $70,000,000. Except for a Rodin sculpture, the holdings of the Trust during the material period were in bonds and shares, assets which could be characterized generally as of an income-earning nature. I should add, however, that the investment portfolio of the Trust produced a low yield: 1969, 1970 and 1971 earnings amounted to $324,469, $293,178 and $213,588 respectively, providing a return of less than one-half of one per cent on the portfolio's market value. Some of the Trust investments, although possibly bearing income in the long run, did not in fact earn any income over the material period. The financial statements of the Trust disclose, for example, that the Trust's investment in 2nd Preferred Shares of Cemp Investments Ltd. (a private, family corporation) which had a cost base of $3,300,000 yielded no income at all in 1969, 1970 and 1971. Trust investment policies appear to have been focused more on capital gains than on income. Accordingly, the Trust's very substantial asset base generated modest income tax liabilities: the 1970 and 1971 income tax returns filed by the taxpayer show federal tax payable of $12,107.99 and $15,687.98 respectively and in 1972 (when some capital gains were realized and, for the first time, taxable) federal tax was listed as $31,878.00.

   The low-yield investment portfolio of the Trust undoubtedly had detrimental consequences for the beneficiary in respect of the amount of income available under her 50% entitlement. Perhaps to mitigate those consequences, or perhaps for some other reason entirely, the trustees chose to make a capital allocation to the beneficiary of $500,000 (U.S.) on December 29, 1969 and one of $2,000,000 (Can.) on March 4, 1970. There is no suggestion by the Trust that these allocations were in any way designed to enhance the income-earning potential of the Trust. On the contrary, the inevitable result was to reduce the Trust's net income-earning prospects both in the short-term and in the long run owing to the depletion of Trust capital.

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

   The sole witness at trial was Mr. Arnold Ludwick, an accountant, Executive Vice-President of Cemp Investments and Executive Vice-President of Claridge Investments. Claridge Investments managed the business affairs of the taxpayer Trust, subject of course to the ultimate authority of the trustees. Mr. Ludwick's evidence concerned the reasons for the borrowing.

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He testified that subject to various constraints on the marketability of some of the Trust investments, 'it certainly would have been possible to, in an orderly way, liquidate investments' to fund the capital allocation. The funds were borrowed because such a disposition of assets would have been commercially inadvisable. As testified by Mr. Ludwick:

 

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

 

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

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

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

II

LEGISLATION

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

 

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

 

 

(a)

 

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

 

 

 

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

 

 

 

. . .

 

 

(c)

 

an amount paid in the year or payable in respect of the year (depending upon the method regularly followed by the taxpayer in computing his

 

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income), pursuant to a legal obligation to pay interest on

 

 

(i)

 

borrowed money used for the purpose of earning income from a business or property (other than borrowed money used to acquire property the income from which would be exempt or to acquire an interest in a life insurance policy). . .

 

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

 

   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;

 

 

 

   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). . .

 

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

III

JUDGMENTS

 (a) Tax Review Board

   Mr. Guy Tremblay [78 DTC 1752] began his reasons for judgment by noting that the burden was on the Trust to show that the assessments were incorrect. He added:

 

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

 

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

 

Surely, what must have been intended by section 11(1)(c) was that the interest should be deductible for the years in which the borrowed capital was employed in the business rather than that it should be deductible for the life of the loan as long as its first use was in the business.

 

The main case on which the Crown relied to rebut the Trans-Prairie case was Sternthal v. The Queen (1974), 74 DTC 6646 (F.C.T.D.). In Sternthal, a taxpayer with a large excess of assets over liabilities borrowed a sum of $246,800. On the same day he gave interest-free loans to his children totalling $280,000. The taxpayer argued that he was entitled to use his assets to make loans to his children and to borrow for the purpose of 'filling the gap' left by the making of such loans. Therefore, he argued, as long as the assets which made the loan possible were used to produce income, interest on the borrowing was deductible. Mr. Justice Kerr did not agree. He held that the taxpayer used the borrowed money to make non-interest bearing loans to his children, not for the purpose of earning income. The taxpayer chose to find the money for the loans by borrowing and the fundamental purpose of the borrowing was to make the loans.

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

 (b) Federal Court -- Trial Division

   The Trust took its suit to the Federal Court -- Trial Division where it was heard de novo by Justice Marceau ([1980] 2 F.C. 433 [79 DTC 1752]). The Trust maintained its contention that even if the proceeds of the loans negotiated with the Bank were actually used to pay the allocations made in favour of the beneficiary, they must still be deemed to have been 'used for the purpose of earning income from property' within the meaning of the Act, since their use allowed the Trust to retain securities which were income producing and which moreover increased in value before the loans were redeemed. Marceau J. said at p. 454, 'The defendant [i.e., the Crown] disagrees, and in my view rightly so.' More detailed evidence was produced regarding the assets held by the

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Trust. Nevertheless, Marceau J. dismissed the appeal. He, like Mr. Tremblay of the Tax Review Board, accepted the principle that it is the actual and real effect of a transaction or series of transactions that was relevant, rather than its 'legal' or apparent aspect. If the transactions in the present case had merely changed the composition of the income-earning property of the Trust by liquidating one debt and substituting another, then he would have accepted the proposition that the real purpose of the transactions was to earn income from the Trust. He concluded, however, that the net effect of the trustees' actions was to reduce the income-earning property of the Trust by some $2,500,000. Marceau J. pointed out that at p. 456:

 

 . . .the decision here sought by the plaintiff would mean that without doing anything that could enhance the value of its property, nor even anything that could change the composition of its assets, the trust could nevertheless render non-taxable part of its income.

 

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

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

 (c) Federal Court of Appeal

   In the Federal Court of Appeal [1983] 2 F.C. 797 [83 DTC 5243], Thurlow C.J., Hyde D.J. concurring, allowed the Trust's appeal. Thurlow C.J. held that the use of the borrowed money to pay the capital allocations was what enabled the trustees to keep the income-yielding Trust investments and to exploit them by obtaining for the Trust the income they were earning. Chief Justice Thurlow said at pp. 800-801:

 

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



source:
as found on an 'odd' mislink on a Canadian site
But we were able to correct it and this is what we found.....
http://www.uottawa.ca/academic/commonlaw/pgs/eng/vir/fac/vkrishna/Basic%20Tax%20Web/Cases.syllabus/Bronfman.htm



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