Ludco Enterprises Ltd. v. Canada

Ludco Enterprises Ltd. v. Canada
Collection
Supreme Court Judgments
Date
2001-09-28
Neutral citation
2001 SCC 62
Report
[2001] 2 SCR 1082
Case number
27320
Judges
Gonthier, Charles Doherty; Iacobucci, Frank; Major, John C.; Bastarache, Michel; Binnie, William Ian Corneil; Arbour, Louise; LeBel, Louis
On appeal from
Federal Court of Appeal
Subjects
Civil procedure
Taxation
Notes
SCC Case Information: 27320
Decision Content
Ludco Enterprises Ltd. v. Canada, [2001] 2 S.C.R. 1082, 2001 SCC 62
Ludco Enterprises Ltd., Brian Ludmer, David Ludmer,
and Cindy Ludmer Appellants
v.
Her Majesty The Queen Respondent
Indexed as: Ludco Enterprises Ltd. v. Canada
Neutral citation: 2001 SCC 62.
File No.: 27320.
2001: March 19; 2001: September 28.
Present: Gonthier, Iacobucci, Major, Bastarache, Binnie, Arbour and LeBel JJ.
on appeal from the federal court of appeal
Income tax – Deductions – Interest – Legal test for interest deductibility – Income Tax Act, R.S.C. 1985, c. 1 (5th Supp .), s. 20(1) (c)(i).
Income tax – Deductions – Interest – Taxpayers seeking deduction of interest paid on borrowed money used to purchase shares in foreign companies – Taxpayers receiving $600,000 in dividends and incurring $6 million in interest costs during period shares held in foreign companies – Whether interest costs deductible – Whether money borrowed “used for the purpose of earning income” – Concepts of “purpose” and “income” – Income Tax Act, R.S.C. 1985, c. 1 (5th Supp .), s. 20(1) (c)(i).
Income tax – Deductions – Interest – Corporate taxpayer seeking deduction of interest paid on borrowed money used to purchase shares in foreign companies – Shares disposed of in rollover transaction – Whether taxpayer entitled to deduct interest costs incurred after rollover transaction – Whether taxpayer established link between original eligible use property and current eligible use property – Income Tax Act, R.S.C. 1985, c. 1 (5th Supp .), s. 20(1) (c)(i).
Costs – Special costs – Revenue Canada denying taxpayers’ interest deductions and aggressively pressing its case against taxpayers – Revenue Canada’s reassessment set aside – Whether special costs should be awarded – Supreme Court Act, R.S.C. 1985, c. S-26, s. 47 .
Two foreign companies operated investment funds carefully structured to avoid the application of the Foreign Accrual Property Income (“FAPI”) rules and to provide other tax advantages to investors. Between September 1977 and June 1979, L, the President and sole shareholder of the corporate appellant (“Ludco”), purchased shares in the foreign companies on behalf of Ludco and the individual appellants, investing approximately $7.5 million using $6.5 million in borrowed funds. In 1983, Ludco disposed of the shares in the foreign companies along with other assets to a wholly owned subsidiary of Ludco for their fair market value and in accordance with the rollover provisions in s. 85 of the Income Tax Act . It received both interest-earning and non-interest-earning assets as consideration. In 1985, when the FAPI rules eliminated the tax benefits of the type of off-shore investment in issue, the appellants disposed of their shares and earned capital gains of approximately $9.2 million. In the eight years the appellants held shares in the foreign companies, they received approximately $600,000 in dividends and incurred approximately $6 million in interest charges. For the taxation years 1981 to 1985, the appellants deducted their interest costs against other reported income pursuant to s. 20(1) (c)(i) of the Income Tax Act . They were reassessed and the deductions were disallowed. The Minister of National Revenue took the position that the amount borrowed had not been “used for the purpose of earning income from a business or property” as stipulated in s. 20(1) (c)(i), but to defer taxes and convert income into capital gains. The Tax Court of Canada, the Federal Court, Trial Division, and the majority of the Federal Court of Appeal all upheld the Minister’s reassessments.
Held: The appeal should be allowed. The interest costs were deductible under s. 20(1) (c)(i) of the Income Tax Act .
Per Gonthier, Iacobucci, Major, Bastarache, Binnie and Arbour JJ.: Whether a taxpayer’s purpose in making an investment falls within the ambit of s. 20(1) (c)(i) of the Income Tax Act is a question of mixed fact and law. Determining and applying the proper test under s. 20 is a question of law. In this case, since the trial judge did not apply the correct legal test to determine the appellants’ purpose, this Court may interfere with his finding in this regard.
The use of the borrowed money in this case complies with the requirements expressed in s. 20(1) (c)(i), including the requirement that the borrowed money be “used for the purpose of earning income”. A determination of whether borrowed money has been put to an eligible use requires a characterization of the use of the borrowed funds and of the taxpayer’s purpose in using the funds. Here, the borrowed funds were directly used to purchase shares in the foreign companies, so the focus of the inquiry is whether the taxpayers’ purpose in so using the funds was to earn income within the meaning of s. 20(1) (c)(i).
The requisite test to determine the purpose for interest deductibility under s. 20(1) (c)(i) is whether, considering all the circumstances, the taxpayer had a reasonable expectation of income at the time the investment was made. When the modern rule of statutory interpretation is applied, only the reasonable expectation of income test is consistent with the wording of s. 20(1) (c)(i). Although many courts have simply adopted the bona fide purpose test, it is not supported by the principles of statutory interpretation, especially as applied in our recent tax law jurisprudence. Nor does the text of s. 20(1) (c)(i) indicate that the requisite purpose must be the exclusive, primary or dominant purpose, or that multiple purposes are to be somehow ranked in importance in order to determine the taxpayer’s “real” purpose. Absent a sham, window dressing or other vitiating circumstances, a taxpayer’s ancillary purpose may be nonetheless a bona fide objective of his or her investment, equally capable of providing the requisite purpose for interest deductibility.
For the purposes of s. 20(1) (c)(i), “income” refers to income subject to tax, not net income. This definition of income is more consistent with the objective of the interest deductibility provision, which is to create an incentive to accumulate capital with the potential to produce income by allowing taxpayers to deduct interest costs associated with its acquisition. Absent vitiating circumstances, courts should not be concerned with the sufficiency of the income expected or received. Although the income earned in this case was relatively nominal compared to the capital gains realized and interest deductions sought, an “economic realities” view of the investments is not appropriate as it would stray from the express terms of s. 20(1) (c)(i) and supplement the provision with extraneous policy concerns. Here, the requisite purpose was present. Although earning income was not the principal factor that motivated L to invest in the foreign companies, he anticipated the receipt of dividend income and the objective documentary evidence indicates that the appellants had a reasonable expectation of earning income. Furthermore, dividend income was actually received. The purchases of the shares were genuine investments and the amount of dividends actually paid cannot be characterized as window dressing or sham.
The disposition by Ludco of its shares in the foreign companies to its subsidiary in 1983 did not affect its ability to deduct the interest costs. Ludco met the burden of establishing the necessary linkage between the original eligible use property and the current eligible use property. Although Ludco initially received a mix of income-earning and non-income-earning assets as consideration for the shares in the foreign companies, the value of the income-earning assets exceeded the amount of the borrowed money. In these circumstances, the income-producing replacement property can be linked to the entire amount of the loan and it can be said that the interest charges were “wholly applicable” to the source of the income. Consequently, the entire amount of the interest payment continued to be deductible after the rollover occurred.
This is not an appropriate case for an order for special costs pursuant to s. 47 of the Supreme Court Act . Although the Crown aggressively pressed its case against the appellants, there is no substance to the appellants’ claims of abuse and misconduct.
Per LeBel J.: Subject to comments made on the interpretation of tax statutes in the companion case of Singleton v. Canada, [2001] 2 S.C.R. 1046, 2001 SCC 61, there is agreement with the disposition of this appeal.
Cases Cited
By Iacobucci J.
Referred to: Singleton v. Canada, [2001] 2 S.C.R. 1046, 2001 SCC 61; Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32; Rizzo & Rizzo Shoes Ltd. (Re), [1998] 1 S.C.R. 27; Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536; Symes v. Canada, [1993] 4 S.C.R. 695; Canada v. Antosko, [1994] 2 S.C.R. 312; Québec (Communauté urbaine) v. Corp. Notre-Dame de Bon-Secours, [1994] 3 S.C.R. 3; Friesen v. Canada, [1995] 3 S.C.R. 103; Schwartz v. Canada, [1996] 1 S.C.R. 254; Alberta (Treasury Branches) v. M.N.R., [1996] 1 S.C.R. 963; 65302 British Columbia Ltd. v. Canada, [1999] 3 S.C.R. 804; Will-Kare Paving & Contracting Ltd. v. Canada, [2000] 1 S.C.R. 915, 2000 SCC 36; Royal Bank of Canada v. Sparrow Electric Corp., [1997] 1 S.C.R. 411; Canderel Ltd. v. Canada, [1998] 1 S.C.R. 147; Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622; Neuman v. M.N.R., [1998] 1 S.C.R. 770; Hickman Motors Ltd. v. Canada, [1997] 2 S.C.R. 336; Duha Printers (Western) Ltd. v. Canada, [1998] 1 S.C.R. 795; Continental Bank Leasing Corp. v. Canada, [1998] 2 S.C.R. 298; Spire Freezers Ltd. v. Canada, [2001] 1 S.C.R. 391, 2001 SCC 11; Backman v. Canada, [2001] 1 S.C.R. 367, 2001 SCC 10; Moldowan v. The Queen, [1978] 1 S.C.R. 480; Mark Resources Inc. v. The Queen, 93 D.T.C. 1004; Tennant v. M.N.R., [1996] 1 S.C.R. 305.
By LeBel J.
Referred to: Singleton v. Canada, [2001] 2 S.C.R. 1046, 2001 SCC 61.
Statutes and Regulations Cited
Income Tax Act, R.S.C. 1985, c. 1 (5th Supp .), ss. 9 , 18(1) (b), 20(1) (c)(i), 85 , 96 .
Supreme Court Act, R.S.C. 1985, c. S-26, s. 47 .
Authors Cited
Driedger, Elmer A. Construction of Statutes, 2nd ed. Toronto: Butterworths, 1983.
Krishna, Vern. The Fundamentals of Canadian Income Tax, 6th ed. Scarborough, Ont.: Carswell, 2000.
APPEAL from a judgment of the Federal Court of Appeal (1999), 240 N.R. 70, 99 D.T.C. 5153, [1999] 3 C.T.C. 601, [1999] F.C.J. No. 402 (QL), affirming a decision of the Federal Court, Trial Division (1997), 139 F.T.R. 241, 98 D.T.C. 6045, [1997] F.C.J. No. 1707 (QL), affirming a decision of the Tax Court of Canada, 93 D.T.C. 1351, [1993] 2 C.T.C. 2494, [1993] T.C.J. No. 1 (QL), dismissing the plaintiffs’ appeal from the reassessment made under the Income Tax Act for the 1981-1985 taxation years. Appeal allowed.
Guy Du Pont, François Barette and Robert Raizenne, for the appellants.
Pierre Cossette and Sophie-Lyne Lefebvre, for the respondent.
The judgment of Gonthier, Iacobucci, Major, Bastarache, Binnie and Arbour JJ. was delivered by
Iacobucci J. –
I. Introduction
1 In this appeal, we are asked to decide whether interest charges incurred with respect to money the appellants borrowed to purchase shares in two foreign companies are deductible from their income from other sources pursuant to s. 20(1) (c)(i) of the Income Tax Act, R.S.C. 1985, c. 1 (5th Supp .).
2 The appeal was heard at the same time as Singleton v. Canada, [2001] 2 S.C.R. 1046, 2001 SCC 61, reasons in which are being released concurrently herewith. The main issue in both cases is the same: whether the money borrowed by the taxpayers was “used for the purpose of earning income from a business or property” within the meaning of s. 20(1) (c)(i) of the Income Tax Act . However, the resolution of this issue requires a characterization of both the “use” of borrowed funds and the “purpose” of the use (see Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32, at p. 46), and it is at this point that the inquiry in the two appeals diverges. In Singleton, the Court is asked to characterize the “use” of the borrowed funds, whereas in the present appeal we are primarily concerned with the proper characterization of the taxpayer’s “purpose” in using the borrowed money.
3 In my view, the requisite use and purpose were present in the circumstances of this case, and the requirements for interest deductibility under s. 20(1) (c)(i) were met. Consequently, I would allow the appeal for substantially the same reasons given by Létourneau J.A. in dissent at the Federal Court of Appeal.
II. Facts
A. The Companies
4 The two companies at issue in this case, Justinian Corporation S.A. (“Justinian”) and Augustus Corporation S.A. (“Augustus”), operated investment funds that were carefully structured to avoid the application of the Foreign Accrual Property Income rules (the “FAPI” rules) and to provide other tax advantages to investors such as deferral of taxes and the conversion of income into capital gains. It was the policy of Justinian and Augustus (together the “Companies”) to invest in debt-securities and reinvest almost all profits, retaining only a relatively small portion for the purpose of dividend distribution. In the eight years the appellants held shares in the Companies, they received approximately $600,000 in dividends, but incurred approximately $6 million in interest charges. After the FAPI rules were amended to eliminate the tax advantages of these investment funds, the appellants disposed of their shares and earned capital gains of approximately $9.2 million.
5 By way of background, it is useful to outline the taxation environment within which the Companies were set up. A document prepared in September 1976 by the Montreal law firm, Verchère & Gauthier, entitled “Memorandum Respecting the Establishment of a Non-Resident Investment Organisation for Canadian Investors”, explained that in 1976 the FAPI rules were implemented to eliminate some foreign vehicles for tax deferral and savings, such as foreign-based family investment corporations or trusts. Under the new rules, passive income of closely held foreign holding companies and trusts was attributed to Canadian shareholders or beneficiaries in the year it was earned, even if not distributed. However, it remained open to Canadians to invest in widely held foreign investment vehicles without incurring current taxation on reinvested income provided that the interest of the Canadian investor was less than 10 percent. The Companies were conceived, and their operations planned, in light of these Canadian income tax laws and the proposal for a new investment vehicle contained in the aforementioned memorandum.
6 For our purposes, the Companies can be treated as essentially the same entity. Both were incorporated in Panama in 1977, and operated from headquarters in the Bahamas. Therefore, as non-residents of Canada, during the material times, the income of the Companies was not taxable under the Income Tax Act . The business activities of the Companies consisted of investing in Canadian and US withholding tax-exempt debt securities or fixed income securities. In order to circumvent the FAPI rules, the Companies’ constituting documents restricted the acquisition and redemption of shares so that no one investor could hold more than a 9.9 percent share interest in the Companies.
7 A 1977 document prepared by Verchère & Gauthier, entitled “Memorandum Respecting the Formation and Operation of the Altanational Bond Fund” summarized the tax features of an investment in what became the Companies in this way:
a) the Fund would not be subject to any Canadian income tax either with respect to interest income or gains on its sales of Fund assets;
b) the Canadian shareholders would not be subject to any income tax with respect to their investment in the Fund except to the extent of dividends received or proceeds of disposition of their shares;
c) proceeds of dispositions of the shares by the Canadian shareholders, whether by way of sale or redemption, would give rise to taxation as capital gains.
8 The Companies’ Explanatory Memoranda set out their investment strategy and dividend policy. Initially, in 1977, the Companies’ strategy was to invest in debt securities and “accumulate earnings for reinvestment”. The dividend policy granted the Boards of Directors a broad discretion to declare and pay a dividend at any time if that was in the best interests of the Companies and their shareholders. In 1978, the Companies’ strategy was modified slightly to “accumulate the major portion of its earnings for reinvestment”. Furthermore, the dividend policy was changed to indicate that “in each year that the Fund has earnings it is anticipated that the Board of Directors of the Fund will declare and pay a dividend to shareholders of some portion of the Fund’s earnings”. By 1981, the dividend policy reflected the practice of the Companies since 1977. It provided that, “in the past, it has been the policy of the Board of Directors of the Fund to declare and pay a dividend to shareholders for years in which the Fund has earnings, and it is anticipated that the Board of Directors will continue to follow this policy”.
9 In fact, beginning in December 1978, the Companies did declare an annual dividend of US$1 per share for each year of their existence.
B. The Investments
10 In addition to the tax advantages presented, an investment in the Companies was made attractive by the fact that the funds were managed by a Mr. Ronald Meade, whose expertise and success in this area was renowned. One of the investors who became interested in the Companies was a businessman and real estate developer named Irving Ludmer. Mr. Ludmer was the President and sole shareholder of the corporate appellant, Ludco Enterprises Ltd. (“Ludco”). He is also the father of the individual appellants in this case (the “Ludmer children”). Mr. Ludmer was introduced to the opportunity to invest in the Companies by a former business colleague named Arnold Steinberg. Mr. Steinberg had been a client of Mr. Meade and communicated to Mr. Ludmer his confidence that an investment in the Companies would be worthwhile.
11 Between September 1977 and June 1979, Mr. Ludmer entered into five separate transactions whereby he purchased shares in the Companies on behalf of Ludco and the Ludmer children. In October 1977, the Ludmer children acquired a total of 10,000 shares of Justinian at US$100 per share. In July 1978, they doubled their holdings. The total acquisition cost of their investment was $2.2 million. In July and December 1978, Ludco invested a total of $2.3 million in Augustus. Approximately eighty percent of these four investments were financed with funds borrowed from Canadian chartered banks in different loans at floating rates of prime plus 1 percent or 3/4 percent. The carrying cost of the appellants’ loans increased from about 10 percent in late 1977, through 14 percent in 1979 to a peak of 20 percent in early 1981 before stabilizing at approximately 12 percent in 1983 until the disposition of their shares in 1985. In the fifth of the appellants’ transactions, in June 1979 Ludco invested $3 million in Justinian. All the funds for this acquisition were borrowed through a long-term mortgage on a Ludco-owned shopping centre property with a fixed interest rate of 11.5 percent. In the result, the appellants invested approximately $7.5 million to acquire shares in the Companies, having borrowed a total of $6.5 million to finance their acquisitions.
12 Mr. Ludmer testified at trial and explained the appellants’ reasons for and expectations in investing in the Companies. He sought no professional advice before deciding to invest. His decision was driven principally by Mr. Meade’s previous performance, but other factors included the tax advantages and rumours concerning foreign exchange controls. Mr. Ludmer also read the dividend policy section of the Explanatory Memorandum and anticipated the receipt of dividend income. Mr. Ludmer stated clearly that the appellants would not have invested in the Companies with borrowed funds if he had known that interest costs were not deductible from income.
C. The Rollover
13 On May 12, 1983, the appellant Ludco disposed of a group of investment assets, including the shares in the Companies, to 2154-7203 Québec Inc., a wholly owned subsidiary of Ludco. This disposition was done in accordance with the rollover provisions in s. 85 of the Act. The assets were disposed of for their fair market value of $12,685,000. Ludco received as consideration for the disposition both interest earning and non-interest earning assets. Specifically, Ludco received two non-interest bearing notes (one for $1,780,000 and the other for $5,600,000) totalling $7,380,000, a promissory note in the principal amount of $605,000 and bearing interest at the prime rate of the Mercantile Bank of Canada plus 1 percent, and 94 Class B preferred shares of 2154-7203 Québec Inc. providing an annual fixed dividend of 9 percent and a redemption value of $4,700,000.
14 At the time of the disposition, the market value of the shares in the Companies totalled $8,645,715, Ludco’s outstanding debt attributable to the shares in the Companies totalled $4,800,000, and the new income-producing assets received as consideration in the rollover totalled $5,305,000.
15 On the day the rollover occurred, Ludco pledged the 94 Class B preferred shares to Ludco’s parent company, 109395 Canada Inc., to guarantee all indebtedness owing by Ludco to its parent company. At the same time, Ludco pledged the non-interest bearing promissory note of $1,780,000 to the Mercantile Bank of Canada as security for the loan used to purchase the shares of the Companies.
16 On September 6, 1985, the non-interest bearing notes were exchanged for Class D preferred shares of 2154-7203 Québec Inc. providing annual dividends of 8 percent.
D. The Share Redemption and the Tax Consequences
17 In 1984, the FAPI rules were amended to discourage the type of off-shore investment at issue in this case by eliminating the tax benefits and advantages it generated. These amendments, known as the “FAPI amendments”, led to the winding up of the Companies’ businesses.
18 In 1985, upon the coming into force of the FAPI amendments, the taxpayers disposed of their shares and realized a capital gain of $9.24 million. Over the eight years during which the shares had been held by the appellants, they received some $600,000 in dividends. Over the same period they incurred interest costs of $6 million.
19 For the taxation years 1981-1985, the appellants deducted their interest costs against other reported income pursuant to s. 20(1) (c)(i) of the Income Tax Act . In 1986 and 1987, the Minister of National Revenue reassessed the appellants and disallowed those deductions. The Minister took the position that the amount borrowed had not been used “for the purpose of earning income from a business or property” as stipulated in s. 20(1) (c)(i); rather the real purpose of the investment was to defer taxes and convert income into capital gains.
20 Both the documentary evidence and the testimony of Revenue Canada personnel indicated that Revenue Canada’s policy was to allow the deduction of interest on money borrowed to purchase shares even if no dividend was paid to the investor. In particular, written statements of Revenue Canada policy indicated that taxpayers could deduct interest paid in respect of funds used to purchase shares that were precluded from paying taxable dividends, just as they could shares in speculative stock that did not actually realize income.
21 The Tax Court of Canada confirmed the Minister’s reassessments and disallowed the deduction. The Federal Court, Trial Division, and a majority of the Federal Court of Appeal also disallowed the deduction. Létourneau J.A., in dissent, would have allowed the deduction.
III. Relevant Statutory Provisions
22 Section 20(1) (c)(i) of the Income Tax Act, R.S.C. 1985, c. 1 (5th Supp .), provides:
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 on the method regularly followed by the taxpayer in computing the taxpayer’s 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;
IV. Judgments Below
A. Tax Court of Canada, 93 D.T.C. 1351
23 In determining whether the interest charges were deductible in this case, Tremblay J.T.C.C. interpreted the term “income” in s. 20(1) (c)(i) to mean profit or net income. He reviewed the evidence in detail and found that the appellants’ interest expenses far exceeded their dividend earnings, both actual and anticipated. Accordingly, he held that the appellants did not have a reasonable expectation of earning net dividend income from their investment, and hence the interest charges in question were not deductible.
B. Federal Court, Trial Division, 98 D.T.C. 6045
24 An appeal from the decision of the Tax Court of Canada was heard by way of trial de novo. Lutfy J. interpreted s. 20(1) (c)(i) as requiring a reasonable expectation of net income before interest deductibility could be triggered under that provision. After a comprehensive review of the evidence, Lutfy J. accepted that, at the time of their initial investments in the Companies, the appellants did have a reasonable expectation of receiving dividends. However, they never expected their dividend income to exceed their interest expenses. Moreover, after reviewing the case law, Lutfy J. concluded that in order to meet this requirement the appellants must satisfy the court that their bona fide or true purpose in making the investments at issue was to earn net income. Instead, Lutfy J. concluded that the appellants’ true purpose was to defer taxes and convert income into capital gains. Therefore, Lutfy J. dismissed the appeal and confirmed the Minister’s reassessment.
C. Federal Court of Appeal (1999), 240 N.R. 70
25 I prefer to deal with the dissenting reasons of Létourneau J.A. prior to those of Marceau J.A. and Desjardins J.A. since the latter two often refer to the position advanced by Létourneau J.A. in their reasons.
1. Létourneau J.A. (Dissenting)
26 Létourneau J.A., in dissent, analysed the arguments respecting s. 20(1) (c)(i) in two parts: first, the requisite intention to earn income, and second, the assertion that the term “income” refers to net income or profit. In regard to the requisite intention to earn income, Létourneau J.A. reviewed the case law and acknowledged that courts have adopted a bona fide or true purpose test to determine whether interest charges are deductible under s. 20(1) (c)(i). He noted, however, that a difficulty arises in the case of an investment in the form of shares or debt securities because of the fact that such an investor is always pursuing a dual purpose. In resolving this difficulty, Létourneau J.A. rejected the introduction of a dominant purpose test into s. 20(1) (c)(i) as being unsupported by the text of the Act, contrary to the objective of the provision and the evidence of Parliamentary intention and likely to create uncertainty and adversely affect the business community. Instead, he concluded that it is sufficient for the investor to have a reasonable expectation of income when investing borrowed money.
27 Létourneau J.A. also rejected the proposition that “income” in s. 20(1) (c)(i) refers to net income or profit. In his view, to the extent that the purpose of the use of the borrowed amount was to acquire or increase capital for the purpose of gross income, the essential condition of s. 20(1) (c)(i) is met.
28 In respect of the s. 85 rollover of Ludco’s shares in the Companies, Létourneau J.A. held that the acquisition of the taxable income-producing replacement property can be traced to the entire amount of the balance of the loan at the time of the transfer. Therefore, the appellant Ludco did not lose the benefit of the interest deduction when it replaced its original source of income with another source that also generated taxable income. Accordingly, Létourneau J.A. would have allowed the appeal and permitted the deduction of interest charges in this case.
2. Desjardins J.A.
29 After noting that the case law refers to the taxpayer’s real or true purpose in matters of interest deductibility under s. 20(1) (c)(i), Desjardins J.A. agreed with Létourneau J.A.’s rejection of a dominant purpose test. Furthermore, she stated that she shared Létourneau J.A.’s views that a taxpayer need only have had a reasonable expectation of income at the moment the investment was made, and that the borrowed money must have been used to acquire property for the purpose of deriving gross, not net, income. However, Desjardins J.A. went on to find that the evidence in this case clearly established that the appellants’ real purpose when they borrowed the money was to make capital gains. She held that because receiving dividends was not the real objective of the appellants’ investments in the Companies, the interest paid is not deductible under s. 20(1) (c)(i).
3. Marceau J.A.
30 Marceau J.A. admitted to having some difficulty with the introduction of a dominant purpose test into s. 20(1) (c)(i). However, in his view Parliament clearly intended for interest deductibility to be triggered only where the taxpayer’s actual or true intention was to earn income. In addition, it was Marceau J.A.’s view that the trial judge made a finding of fact that the appellants’ true purpose in investing in the Companies as structured was to defer tax and transform the income into capital gains. In his view, this finding of fact is not contradicted by the evidence and therefore is not subject to appellate interference. Accordingly, Marceau J.A. concluded that the statutory requirements for the deduction of interest were not met in this case and that the Minister’s reassessment should be upheld.
V. Issues and Submissions of the Parties
31 1. What is the legal test for interest deductibility under s. 20(1) (c)(i)?
2. Are the interest costs incurred by the appellants deductible in this case?
3. Should special costs be awarded in this case?
32 The appellants submit that the lower courts erred in two ways: first, by introducing a dominant or true purpose test into s. 20(1) (c)(i) and, second, by interpreting the term “income” in that provision to mean net income or profit. The appellants state that these errors lead to an interpretation of s. 20(1) (c)(i) that is impractical and contrary to the plain meaning and objective of the provision. The appellants argue that the use of the borrowed money in this case complies with all of the requirements expressed in s. 20(1) (c)(i) and, in particular, with the requirement that the borrowed money was used for the purpose of earning income. They also seek special costs for what they characterize as an abuse of Revenue Canada’s assessment power in this case.
33 The respondent submits that in order for interest charges to be deductible it must be the taxpayer’s actual, true or bona fide purpose to use the funds to earn income and the taxpayer must have a reasonable expectation that the borrowing transaction would yield net income. The respondent argues that, in the present context, the trial judge’s identification of the appellants’ true purpose was a finding of fact supported by the evidence and therefore not subject to appellate interference. In the result, she submits that the interest deductions at issue in this case do not meet the statutory requirements of s. 20(1) (c)(i). The respondent also argues that, even if this Court concludes that the interest charges associated with the initial investments are deductible, Ludco lost the ability to deduct interests charges when it rolled over its shares in the Companies. The respondent submits that during the rollover transaction there was a commingling of funds and that Ludco failed to meet its onus to trace the borrowed funds to a current eligible use. Finally, the respondent argues that there should be no award of special costs in this case as there is no evidence of misconduct by the respondent in connection with the litigation.
VI. Analysis
A. The Preliminary Issue: Fact or Law?
34 As a preliminary matter, it was argued that the trial judge made a finding of fact when he determined that the appellants’ true purpose in making the investments at issue was not to earn income but to defer taxes and acquire capital gains. It was further argued that this Court is prevented from revisiting the trial judge’s finding in this regard by the principle that, absent a palpable and overriding error, findings of fact made at trial are not subject to appellate court interference. However, whether or not a taxpayer’s purpose in making an investment falls within the ambit of s. 20(1)(c)(i) of the Act is properly viewed as a question of mixed fact and law. For the reasons set out below, the main issue in this appeal is to determine and apply the proper test under s. 20. That is a question of law. Moreover, in my view, with respect, the trial judge did not apply the correct legal test to determine the appellants’ purpose in this case. Therefore, it is open to this Court to interfere with the finding of the trial judge in this regard.
35 The identification of the correct legal test in this case centres on a question of statutory interpretation. As a result, before discussing the legal test for interest deductibility under s. 20(1) (c)(i), and whether interest costs are deductible in this case, it may be helpful to review briefly the principles of statutory interpretation that apply in this case.
B. Principles of Statutory Interpretation
36 The modern rule of statutory interpretation was put succinctly by E. A. Driedger in Construction of Statutes (2nd ed. 1983), at p. 87:
Today there is only one principle or approach, namely, the words of an Act are to be read in their entire context and in their grammatical and ordinary sense harmoniously with the scheme of the Act, the object of the Act, and the intention of Parliament. . . .
37 This passage from Driedger “best encapsulates” the preferred approach to statutory interpretation: Rizzo & Rizzo Shoes Ltd. (Re), [1998] 1 S.C.R. 27, at paras. 21 and 23. This is the case for the interpretation of any statute, and it is noteworthy that Driedger’s famous passage has been cited with approval by our Court on numerous occasions both in the non-tax and in the tax context: for the latter, see Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536, at p. 578, per Estey J.; Symes v. Canada, [1993] 4 S.C.R. 695, at p. 744, per Iacobucci J., and at p. 806, per L’Heureux-Dubé J.; Canada v. Antosko, [1994] 2 S.C.R. 312, at p. 326; Québec (Communauté urbaine) v. Corp. Notre-Dame de Bon-Secours, [1994] 3 S.C.R. 3, at p. 17; Friesen v. Canada, [1995] 3 S.C.R. 103, at para. 10, per Major J.; Schwartz v. Canada, [1996] 1 S.C.R. 254, at para. 56, per La Forest J.; Alberta (Treasury Branches) v. M.N.R., [1996] 1 S.C.R. 963, at para. 14, per Cory J.; 65302 British Columbia Ltd. v. Canada, [1999] 3 S.C.R. 804, at para. 5, per Bastarache J., and at para. 50, per Iacobucci J.; and Will-Kare Paving & Contracting Ltd. v. Canada, [2000] 1 S.C.R. 915, 2000 SCC 36, at para. 32, per Major J., and at para. 50, per Binnie J.
38 Furthermore, when interpreting the Income Tax Act courts must be mindful of their role as distinct from that of Parliament. In the absence of clear statutory language, judicial innovation is undesirable: Royal Bank of Canada v. Sparrow Electric Corp., [1997] 1 S.C.R. 411, at para. 112. Rather, the promulgation of new rules of tax law must be left to Parliament: Canderel Ltd. v. Canada, [1998] 1 S.C.R. 147, at para. 41. As McLachlin J. (as she then was) recently explained in Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622, at para. 43:
The Act is a complex statute through which Parliament seeks to balance a myriad of principles. This Court has consistently held that courts must therefore be cautious before finding within the clear provisions of the Act an unexpressed legislative intention. . . . Finding unexpressed legislative intentions under the guise of purposive interpretation runs the risk of upsetting the balance Parliament has attempted to strike in the Act. [Citations omitted.]
See also Antosko, supra, at p. 328. Having said this, it is within the jurisdiction of courts to interpret the rules enacted by Parliament, including the elucidation of otherwise undefined concepts such as “income” or “profit”: see Canderel, supra, at para. 42.
39 In addition, given that the Income Tax Act has many specific anti-avoidance provisions and rules, it follows that courts should not be quick to embellish the provisions of the Act in response to concerns about tax avoidance when it is open to Parliament to be precise and specific with respect to any mischief to be prevented: Neuman v. M.N.R., [1998] 1 S.C.R. 770, at para. 63, per Iacobucci J. To do otherwise would be to fail to give appropriate weight to the well-established principle that, absent a provision to the contrary, taxpayers are entitled to arrange their affairs for the sole purpose of achieving a favourable position regarding taxation: see Stubart, supra, at p. 540, per Wilson J., and at p. 557, per Estey J.; Hickman Motors Ltd. v. Canada, [1997] 2 S.C.R. 336, at para. 8, per McLachlin J.; Duha Printers (Western) Ltd. v. Canada, [1998] 1 S.C.R. 795, at para. 88, per Iacobucci J.; Neuman, supra, at para. 63, per Iacobucci J.; Shell Canada, supra, at para. 46, per McLachlin J.
40 With these principles in mind, I turn to consider the legal test for interest deductibility under s. 20(1) (c)(i).
C. The Legal Test for Interest Deductibility Under Section 20(1)(c)(i)
(1) Introduction
41 The deductibility of interest under s. 20(1) (c)(i) of the Income Tax Act has given rise to considerable litigation and has been the topic of much legal commentary, as pointed out by the parties. Many of the features of the interest deductibility provision are matters of settled law. However, as explained below, the appeal at bar raises two novel issues related to the concepts of “purpose” and “income” contained within s. 20(1) (c)(i).
42 Recently, in Shell Canada, supra, at para. 28, McLachlin J., writing for the Court, described the four elements of s. 20(1) (c)(i) that must be present before interest can be deducted:
The provision has four elements: (1) the amount must be paid in the year or be payable in the year in which it is sought to be deducted; (2) the amount must be paid pursuant to a legal obligation to pay interest on borrowed money; (3) the borrowed money must be used for the purpose of earning non‑exempt income from a business or property; and (4) the amount must be reasonable, as assessed by reference to the first three requirements.
43 The first two elements are not in dispute here. As noted above, the focus of the inquiry in this case is clearly on the third element, na