Gifford v. Canada, [2004] 1 S.C.R. 411, 2004 SCC 15
Thomas Gifford Appellant
v.
Her Majesty The Queen Respondent
and
Canadian Bankers Association Intervener
Indexed as: Gifford v. Canada
Neutral citation: 2004 SCC 15.
File No.: 29416.
2003: November 14; 2004: March 4.
Present: McLachlin C.J. and Major, Bastarache, Binnie, Arbour, Deschamps and Fish JJ.
on appeal from the federal court of appeal
Income tax — Income from employment — Deductions — Sales expenses — Purchase of client list — Financial advisor borrowing money to purchase colleague’s client list — Whether payment to purchase client list and interest paid on borrowed funds deductible — Whether payments were “on account of capital” — Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.), s. 8(1)(f).
The appellant and B worked as financial advisors in an investment firm. When B decided to leave the firm, the appellant borrowed $100,000 to purchase B’s client list. They entered into an agreement whereby B agreed to provide a written endorsement of the appellant to each client identified on a client list and direct the firm to transfer those clients to the appellant. B also agreed to a 30-month non-compete clause and agreed not to provide material information about the clients on the list to anyone without the appellant’s consent. The question is whether the appellant could, for tax purposes, deduct from his income either the purchase price or the interest paid on the money he borrowed to make the purchase. The Minister of National Revenue denied the appellant’s claim for a deduction. The Tax Court of Canada allowed both expenditures to be deducted but the Federal Court of Appeal set aside the decision.
Held: The appeal should be dismissed.
The agreement to pay $100,000 to purchase accumulated goodwill and the agreement not to compete were made to create an enduring benefit for the appellant. The payment for this asset was a payment “on account of capital” and s. 8(1)(f)(v) of the Income Tax Act prevents a deduction from being made for such an expense. Under the tests outlined in Johns-Manville, the client list was a capital asset: (1) it significantly expanded the appellant’s client network, the structure within which he earned his employment income; (2) the purchase of someone else’s accumulated goodwill is not the same as the recurring marketing expenses the appellant would have had to incur to create his own goodwill; (3) the payment secured the discontinuance of competition; and (4) it was a payment made with the intention of securing an asset of enduring benefit that would provide the appellant with a lasting advantage. The fact that the transaction occurred between two employees instead of two businesses does not, by itself, change the characterization of the transaction or cause the earlier client list cases to be ignored.
The interest payment in this case is also a payment “on account of capital”, because the funds borrowed to make the payment to B themselves added to the financial capital of the appellant and as such are expressly denied deductibility under s. 8(1)(f)(v) of the Act. When determining the deductibility of interest, the important question is not whether the payment is a capital expenditure but whether it is “on account of capital”. This distinction is particularly important in relation to interest payments because, unlike other capital assets, loan proceeds are seldom retained in the form they are received. This distinction means that under the Income Tax Act it is only necessary in each case to consider what the proceeds of the loan are to the borrower when they are received, and does not require an examination of what those loan proceeds are spent on. If, as here, the money adds to the financial capital, then the payment of interest on that loan will be considered to be a payment “on account of capital”. In circumstances where interest is not a payment “on account of capital”, it may be deducted as long as it meets the other requirements, such as those set out in s. 8(1)(f) or s. 18(1)(a), and is not precluded by some other section of the Act.
The costs in the courts below are confirmed and the appellant is awarded his reasonable and proper costs in this Court.
Cases Cited
Applied: Johns-Manville Canada Inc. v. The Queen, [1985] 2 S.C.R. 46; considered: Canada Safeway Ltd. v. Minister of National Revenue, [1957] S.C.R. 717; Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32; Tennant v. M.N.R., [1996] 1 S.C.R. 305; Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622; referred to: Wharf Properties Ltd. v. Commissioner of Inland Revenue, [1997] 2 W.L.R. 334; Cumberland Investments Ltd. v. The Queen, [1975] C.T.C. 439; The Queen v. Farquhar Bethune Insurance Ltd., [1982] C.T.C. 282; Bennett & White Construction Co. v. Minister of National Revenue, [1949] S.C.R. 287; Steele v. Deputy Commissioner of Taxation (1999), 161 A.L.R. 201.
Statutes and Regulations Cited
Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.), ss. 8(1)(f) [am. 1994, c. 7, Sched. II, s. 5(1)], (j) [idem, ss. 5(4), 5(5)], (2), 9(1), 18(1)(a), (b), 20(1)(a), (b), (c) [idem, s. 15(1)].
Tax Court of Canada Act, R.S.C. 1985, c. T-2, ss. 18, 18.25 [ad. c. 51 (4th Supp.), s. 5].
APPEAL from a judgment of the Federal Court of Appeal (2002), 293 N.R. 111, [2002] 4 C.T.C. 64, 2002 D.T.C. 7197, [2002] F.C.J. No. 1127 (QL), 2002 FCA 301, quashing a decision of the Tax Court of Canada, [2001] 2 C.T.C. 2162, 2001 D.T.C. 168, [2001] T.C.J. No. 100 (QL), and confirming the assessment of the Minister of National Revenue. Appeal dismissed.
Michael Templeton and Richard Thomas, for the appellant.
Gordon Bourgard and Wendy Burnham, for the respondent.
Al Meghji and Mahmud Jamal, for the intervener.
The judgment of the Court was delivered by
1 Major J. — The appellant, Thomas Gifford, a financial advisor and employee of Midland Walwyn Capital Inc. (“Midland Walwyn”), borrowed $100,000 to purchase the list of Mr. Bentley’s clients. Bentley was a fellow financial advisor who was leaving the firm. The question is whether the appellant could, for tax purposes, deduct from his income either the purchase price or the interest paid on the money he borrowed to make the purchase. Neither of these amounts are deductible, as both were payments “on account of capital” which are expressly denied deductibility under s. 8(1)(f)(v) of the Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.) (the “Act”). I would dismiss the appeal.
I. Factual Background
2 The appellant and Bentley were employees of Midland Walwyn in North Bay, Ontario. They worked as financial advisors, each dealing with their own clients.
3 Bentley decided to leave the firm and the appellant entered into an agreement with him on December 10, 1995 titled “Agreement to Purchase Client Base of Financial Advisor” (the “Agreement”), whereby Bentley agreed to provide a written endorsement of the appellant to each client identified on a client list and direct Midland Walwyn to transfer those clients to the appellant. Bentley also agreed to a non-compete clause which, in general terms, precluded him from providing retail securities investment advice to those clients for a period of 30 months, nor could he provide material information about the clients on the list to anyone without the appellant’s consent.
4 In exchange, the appellant paid Mr. Bentley $90,000 on closing and a further $10,000 on April 8, 1996. The hold back of $10,000 was subject to reduction according to a formula in the Agreement if the total amount invested by the clients on the list decreased.
5 The employer Midland Walwyn’s primary consideration was keeping the clients at the firm. The branch manager facilitated the Agreement and transferred the clients to the appellant. Evidence was given that in the absence of the Agreement the appellant would probably only have acquired about one quarter of Mr. Bentley’s clients with the rest distributed to other financial advisors in the firm.
6 The appellant’s claim for a deduction was denied by the Minister of National Revenue. The appellant appealed to the Tax Court of Canada under the informal procedure outlined in s. 18 of the Tax Court of Canada Act, R.S.C. 1985, c. T-2. Bowman A.C.J.T.C. summarized the appellant’s claim to the Minister for a deduction:
In filing his return of income the appellant deducted $13,258.07, which he claimed represented depreciation of goodwill ($5,250) and interest and insurance expense ($8,008.07). The Minister disallowed this amount on the basis that no provision allowed the appellant to deduct an amount as depreciation of goodwill or interest for the purchase of a customer list.
([2001] 2 C.T.C. 2162, at para. 5)
At the Tax Court the appellant shifted his submission and claimed that the payment to Bentley was a current marketing expense made for the purposes of obtaining clients, and that the interest should be deductible as a current expense. Bowman A.C.J.T.C. allowed both expenditures to be deducted and this decision was subsequently reversed by the Federal Court of Appeal.
II. Relevant Statutory Provisions
7 While this appeal can be decided solely on s. 8, the rationale for the decision is aided by the reference to portions of ss. 9, 18 and 20 of the Act which, for convenience, are reproduced below.
8. (1) In computing a taxpayer’s income for a taxation year from an office or employment, 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:
. . .
(f) where the taxpayer was employed in the year in connection with the selling of property or negotiating of contracts for the taxpayer’s employer, and
(i) under the contract of employment was required to pay the taxpayer’s own expenses,
(ii) was ordinarily required to carry on the duties of the employment away from the employer’s place of business,
(iii) was remunerated in whole or part by commissions or other similar amounts fixed by reference to the volume of the sales made or the contracts negotiated, and
(iv) was not in receipt of an allowance for travel expenses in respect of the taxation year that was, by virtue of subparagraph 6(1)(b)(v), not included in computing the taxpayer’s income,
amounts expended by the taxpayer in the year for the purpose of earning the income from the employment (not exceeding the commissions or other similar amounts referred to in subparagraph (iii) and received by the taxpayer in the year) to the extent that those amounts were not
(v) outlays, losses or replacements of capital or payments on account of capital, except as described in paragraph (j),
. . .
(j) where a deduction may be made under paragraph (f), (h) or (h.1) in computing the taxpayer’s income from an office or employment for a taxation year,
(i) any interest paid by the taxpayer in the year on borrowed money used for the purpose of acquiring, or on an amount payable for the acquisition of, property that is
(A) a motor vehicle that is used, or
(B) an aircraft that is required for use in the performance of the duties of the taxpayer’s office or employment, and
(ii) such part, if any, of the capital cost to the taxpayer of
(A) a motor vehicle that is used, or
(B) an aircraft that is required for use in the performance of the duties of the office or employment as is allowed by regulation;
. . .
(2) Except as permitted by this section, no deductions shall be made in computing a taxpayer’s income for a taxation year from an office or employment.
. . .
9. (1) Subject to this Part, a taxpayer’s income for a taxation year from a business or property is the taxpayer’s profit from that business or property for the year.
. . .
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:
(a) such part of the capital cost to the taxpayer of property, or such amount in respect of the capital cost to the taxpayer of property, if any, as is allowed by regulation;
(b) such amount as the taxpayer may claim in respect of a business, not exceeding 7% of the taxpayer’s cumulative eligible capital in respect of the business at the end of the year;
(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),
(ii) an amount payable for property acquired for the purpose of gaining or producing income from the property or for the purpose of gaining or producing income from a business (other than property the income from which would be exempt or property that is an interest in a life insurance policy),
(iii) an amount paid to the taxpayer under
(A) an appropriation Act and on terms and conditions approved by the Treasury Board for the purpose of advancing or sustaining the technological capability of Canadian manufacturing or other industry, or
(B) the Northern Mineral Exploration Assistance Regulations made under an appropriation Act that provides for payments in respect of the Northern Mineral Grants Program, or
(iv) borrowed money used to acquire an interest in an annuity contract in respect of which section 12.2 applies (or would apply if the contract had an anniversary day in the year at a time when the taxpayer held the interest) except that, where annuity payments have begun under the contract in a preceding taxation year, the amount of interest paid or payable in the year shall not be deducted to the extent that it exceeds the amount included under section 12.2 in computing the taxpayer’s income for the year in respect of the taxpayer’s interest in the contract,
or a reasonable amount in respect thereof, whichever is the lesser; [Emphasis added.]
III. Judicial History
A. Tax Court of Canada, [2001] 2 C.T.C. 2162
8 Bowman A.C.J.T.C., the trial judge at the Tax Court of Canada, distinguished earlier cases that characterized the purchase of client lists as a capital expense. He found Bentley did not have a client list to sell because the clients belonged to Midland Walwyn. He considered the tests summarized by this Court in Johns-Manville Canada Inc. v. The Queen, [1985] 2 S.C.R. 46, and concluded the payment to Bentley was a current expense. Bowman A.C.J.T.C. also found the interest payment was a current expense because: (a) it was used to secure a loan for the payment to Bentley, which he had found to be a current expense; (b) nothing about interest makes it inherently a current or capital expense; (c) this Court had not conclusively decided interest was either a current or a capital expense; and (d) s. 8(1)(j) did not completely occupy the field of interest deductibility by an employee. He classified the interest payment as a current expense under s. 8(1)(f).
B. Federal Court of Appeal, [2002] 4 C.T.C. 64, 2002 FCA 301
9 Rothstein J.A., in reversing the Tax Court decision, held the simple lack of a proprietary interest in the list did not preclude the application of previous client list cases. Applying those cases and the tests from Johns-Manville, supra, he found the payment to Bentley to be a capital expense. On the question of interest deductibility, Rothstein J.A. determined that he was prevented from finding interest a current expense for two reasons: (1) earlier decisions of this Court had held that interest was always a capital expense; and (2) the Act was a complete code on the deductibility of interest. His conclusion was that if it were not for these two reasons then, as a matter of logic, he would have agreed the interest payment was a current expense in accordance with the test used by the Privy Council in Wharf Properties Ltd. v. Commissioner of Inland Revenue, [1997] 2 W.L.R. 334.
IV. Issues
10 This appeal raises the following issues:
1. Was the payment to Bentley a current expense deductible under s. 8(1)(f) or a payment on account of capital precluded from deduction by s. 8(1)(f)(v)?
2. Was the interest Mr. Gifford paid on the borrowed funds a current expense deductible under s. 8(1)(f) or a payment on account of capital precluded from deduction by s. 8(1)(f)(v)?
V. Analysis
11 Before turning to the specific issues raised by this appeal, it is useful to review the general scheme for allowing deductions under the Act. The appellant taxpayer here earned income from employment and under the Act could only make deductions, as a result of s. 8(2), if the deduction was expressly allowed under s. 8.
12 If an employee meets the requirements of s. 8(1)(f)(i) to (iv), he is then allowed to deduct any expense made for the purpose of “earning the income from the employment”. If the expense is a payment “on account of capital”, s. 8(1)(f)(v) removes it from the scope of expenses that can be deducted.
13 When the source of income is a business or property as opposed to employment, the scope of available deductions is much broader because s. 9 states that the taxpayer’s income will be the profit from the business or property. In calculating the profit from a business or property a taxpayer can make deductions in accordance with generally accepted accounting principles unless precluded by some other section of the Act. Sections 18(1)(a) and (b) are similar to the portions of s. 8(1)(f) that act as general limits on what can be deducted. Section 18(1)(a) states that only those expenses incurred for the purpose of gaining or producing income from a business or property can be deducted, and s. 18(1)(b) uses similar language as s. 8(1)(f)(v) to, among other things, preclude deductions of payments “on account of capital”.
14 While the general rules are similar, the exceptions create differences in the ability of taxpayers who earn their income from employment as opposed to from business or property to claim deductions in what appear to be similar circumstances.
15 If an employee otherwise meets the requirements of s. 8(1)(f) but is prohibited from making a deduction because the expense is a payment “on account of capital” within s. 8(1)(f)(v), the only exception provided by the Act is s. 8(1)(j). This section allows for the deduction of payments on account of capital where the item purchased is either a motor vehicle or an aircraft in a manner similar to the capital cost allowance deduction under s. 20(1)(a) discussed below. The employee taxpayer is also allowed to deduct the interest paid on money borrowed to purchase either of these items.
16 In contrast, a taxpayer earning income from business or property may be able to deduct expenses that fall within s. 18(1)(b) pursuant to a number of exceptions in the Act. Two of the more common exceptions are in s. 20(1)(a) and (b). Section 20(1)(a) allows a portion of the capital cost of certain property to be deducted from this income, if the regulations provide for a capital cost allowance in relation to that type of property. Section 20(1)(b) provides a similar deduction for expenditures to purchase certain intangible capital assets, such as goodwill. Section 20(1)(c) is a specific provision that allows interest to be deducted when it is paid on money borrowed for certain purposes.
17 That employees are treated differently than taxpayers earning income from business or property under the Act is not novel nor readily seen as fair. It has resulted in significant litigation when taxpayers attempted, with limited success, to cast themselves as independent business owners as opposed to employees to attempt to get the advantage of the more favourable deductions.
18 If the payment to Bentley or the interest payment are payments “on account of capital”, the appellant, as an employee, will not be able to make any deductions from his income for these expenses. Conversely, if the appellant was earning income from a business and not from employment, he would likely be able to deduct both these payments in calculating his profit for the year. This seemingly inequitable result for the appellant is the result of the structure of the Act but cannot alter the characterization of these payments.
A. The Payment to Mr. Bentley
19 I agree with Rothstein J.A. that the purchase of client lists was not a new consideration, and that the facts of this case did not distinguish it from the earlier cases, making this a payment on account of capital, contrary to Bowman A.C.J.T.C.’s finding at trial. The leading cases on characterizing the purchase of client lists are Cumberland Investments Ltd. v. The Queen, [1975] C.T.C. 439 (F.C.A.), and The Queen v. Farquhar Bethune Insurance Ltd., [1982] C.T.C. 282 (F.C.A.). In addition to the specific cases dealing with client lists, a leading authority on whether an expense is a current expense or a payment on account of capital is Johns-Manville, supra. Rothstein J.A. found, and I agree, the tests in Johns-Manville support the finding that the payment was “on account of capital”.
20 What Bentley had to sell was goodwill, developed over years of dealing with his clients, and the agreement not to compete with the appellant. The appellant was interested in Bentley’s relationship with his clients and not just the names on the list. The Agreement required Bentley to provide written endorsements of the appellant to a specific group of clients and not to compete for them for 30 months. If the appellant only wanted access to the names of the clients he theoretically would not have needed to involve Bentley at all and could have dealt directly with Midland Walwyn. The fact that the transaction occurred between two employees instead of two businesses does not, by itself, change the characterization of the transaction or cause the earlier client list cases to be ignored.
21 Under the tests outlined in Johns-Manville, supra, the client list was a capital asset for a number of reasons. It significantly expanded Mr. Gifford’s client network, the structure within which he earned his employment income. The purchase of someone else’s accumulated goodwill is not the same as the recurring marketing expenses the appellant would have had to incur to create his own goodwill. As well this payment secured the discontinuance of competition. Finally, it was a payment made with the intention of securing an asset of enduring benefit that would provide Mr. Gifford with a lasting advantage.
22 The trial judge found that this payment did not result in the acquisition of an enduring asset because “[c]lients are fleeting, volatile and evanescent” (para. 13). The fact that, if not properly cared for, the asset may decrease in value cannot determine the question of what the asset was to the purchaser at the time of acquisition. A building purchased as a rental property does not lose its characterization as a capital asset if it burns down the day after the sale closes. The goodwill and the agreement not to compete amounted to a capital asset to Mr. Gifford. The payment for this asset was a payment “on account of capital” which could not be deducted from his income because of s. 8(1)(f)(v).
B. Interest
23 The question under the second issue is whether the interest paid by the appellant on the money he borrowed to purchase Bentley’s client list is deductible. As discussed above, an expense can be deducted by an employee under s. 8(1)(f) if it is made for the purpose of earning income from his employment and is not a payment “on account of capital” that would be precluded from deduction by s. 8(1)(f)(v).
24 To determine whether the interest paid by Mr. Gifford was “on account of capital” it is necessary to consider three subsidiary issues: (1) whether this Court has declared the payment of interest is always a payment “on account of capital”; (2) whether the Act provides a complete code to interest deductibility; and (3) what test should be used to classify an interest payment for the purposes of the Act.
(1) Has This Court Held That an Interest Payment Is Always a Payment “On Account of Capital”?
25 This case is an opportunity to address the question as the appellant was an employee and therefore not able to rely on s. 20(1)(c) to make a deduction if this interest payment is held to be “on account of capital”. Rothstein J.A. considered this question at para. 35:
In my respectful opinion, the Tax Court Judge erred in law when he concluded that he was not precluded by Supreme Court jurisprudence from treating interest as a current expense in this case. As I read the relevant decisions, in the absence of statutory provisions permitting the deduction of interest, interest is considered a non‑deductible capital expenditure. [Emphasis added.]
It may be doubtful that the authorities support a statement as broad as that. The cases referred to by him were primarily concerned with whether the interest payment in question could be deducted under s. 20(1)(c) and the comments made with respect to interest in general must be read in that light.
26 Interest has not been held to always be a capital expense. The position in Canada is that loan proceeds are usually additions to the financial capital of the borrower and interest is usually a payment on account of that financial capital. Because interest payments are usually payments “on account of capital”, they are precluded from deduction either by s. 8(1)(f)(v) or by s. 18(1)(b).
27 In Bennett & White Construction Co. v. Minister of National Revenue, [1949] S.C.R. 287, Rand J. recognized that the proceeds of a loan added to the capital of the borrower. See pp. 292-93:
The acquisition of capital may be by various methods including stock subscriptions, permanent borrowings through issues of securities, or term loans; and ordinarily it should make no difference in taxation whether a company carried on financially by one means or another. In the absence of statute, it seems to be settled that to bring interest paid on temporary financing within deductible expenses requires that the financing be an integral part of the business carried on. That is exemplified where the transactions are those of daily buying and selling of securities: Farmer v. Scottish North American Trust [[1912] A.C. 118]; or conversely lending money as part of a brewery business: Reid’s Brewery v. Mail [[1891] 2 Q.B. 1]. [Emphasis added.]
28 In this case we must analyse the foundation upon which Rothstein J.A. relied in stating that this Court has held that interest is always a capital expense. Rand J.’s reasons in Canada Safeway Ltd. v. Minister of National Revenue, [1957] S.C.R. 717, are used to support that proposition. The interest in that case was not deductible because it was found to be an expense incurred to earn exempt income and therefore precluded from deduction by the Act at the time. In a concurring judgment, Rand J. made this comment about the deductibility of interest, at p. 727:
It is important to remember that in the absence of an express statutory allowance, interest payable on capital indebtedness is not deductible as an income expense. If a company has not the money capital to commence business, why should it be allowed to deduct the interest on borrowed money? The company setting up with its own contributed capital would, on such a principle, be entitled to interest on its capital before taxable income was reached, but the income statutes give no countenance to such a deduction. To extend the statutory deduction in the converse case would add to the anomaly and open the way for borrowed capital to become involved in a complication of remote effects that cannot be considered as having been contemplated by Parliament. What is aimed at by the section is an employment of the borrowed funds immediately within the company’s business and not one that effects its purpose in such an indirect and remote manner. [Emphasis added.]
29 A review of the first sentence demonstrates that Rand J. did not hold that interest could never be deducted in the absence of a specific statutory provision but, with his reference to capital indebtedness, limited his statement to interest on money borrowed for use as capital.
30 The next case raising the same issue is Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32. In that case this Court was asked to determine whether interest on money borrowed to make a capital distribution from a trust could be deducted under s. 20(1)(c). Before he analysed that particular issue Dickson C.J. made a preliminary comment about the deductibility of interest. At p. 45, he stated:
It is perhaps otiose to note at the outset that in the absence of a provision such as s. 20(1)(c) specifically authorizing the deduction from income of interest payments in certain circumstances, no such deductions could generally be taken by the taxpayer. Interest expenses on loans to augment fixed assets or working capital would fall within the prohibition against the deduction of a “payment on account of capital” under s. 18(1)(b): Canada Safeway Ltd. v. Minister of National Revenue, [1957] S.C.R. 717, at pp. 722‑23 per Kerwin C.J. and at p. 727 per Rand J. [Emphasis added.]
31 Dickson C.J. made it clear that when the proceeds of a loan added to the financial capital of the borrower, the interest on that loan would be considered a payment “on account of capital”. Iacobucci J. followed this line of reasoning in Tennant v. M.N.R., [1996] 1 S.C.R. 305, at para. 16:
In my opinion, s. 20(1)(c)(i) is not ambiguous. It clearly states that interest can be deducted as an expense when the interest is paid or payable in the taxation year pursuant to a legal obligation to pay interest, and when the interest is payable on money borrowed for the purpose of earning income from a business or property. The purpose of the interest deduction provision is to encourage the accumulation of capital which would produce taxable income, as Dickson C.J. noted in Bronfman Trust, supra, at p. 45. But for s. 20(1)(c)(i), the deduction of interest payments would be prevented by s. 18(1)(b) (Canada Safeway Ltd. v. Minister of National Revenue, [1957] S.C.R. 717; some commentators suggest that Canada Safeway is wrongly decided; see P. W. Hogg and J. E. Magee, Principles of Canadian Income Tax Law (1995), at p. 221, note 36; however, I need not address that issue in these reasons). [Emphasis added.]
32 By stating that the purpose of s. 20(1)(c) is to encourage the accumulation of capital before referring to the interest precluded from deduction by s. 18(1)(b), it seems clear that Iacobucci J. held only that interest on money that adds to the capital of the borrower is prevented from being deducted. The case cannot be used to support the position that, as a result of s. 18(1)(b), interest payments are never deductible. In Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622, McLachlin J. (as she then was) continued to follow the line of authority that began in Canada Safeway, supra. At para. 28, she stated:
Section 20(1)(c)(i) allows taxpayers to deduct from their income interest payments on borrowed money that is used for the purpose of earning income from a business or property. It is an exception to s. 9 and s. 18(1)(b), which would otherwise prohibit the deduction of amounts expended on account of capital, i.e., interest on borrowed funds used to produce income: Canada Safeway Ltd. v. Minister of National Revenue, [1957] S.C.R. 717, at pp. 722‑23, per Kerwin C.J., and at p. 727, per Rand J.; Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32, at p. 45, per Dickson C.J. [Emphasis added.]
At paragraph 74, she again referred to Canada Safeway:
Furthermore, it is important to underline that interest expenses on money used to produce income from a business or property are only deemed by s. 20(1)(c)(i) to be current expenses and, in the absence of that provision, would be considered to be capital expenditures: Canada Safeway, supra, per Rand J., at p. 727. This Court was not invited on this appeal to revisit this characterization of such interest expenses: they therefore remain capital expenses which s. 20(1)(c)(i) deems to be deductible from Shell’s gross income notwithstanding the general prohibition of such capital deductions in s. 18(1). [First emphasis in original; second emphasis added.]
33 Shell was a case where the focus was not on whether the deduction was prohibited by s. 18(1)(b) but on whether, if it was prohibited, it could nevertheless be deducted under s. 20(1)(c).
34 McLachlin J. stated that the Court was not asked to consider how interest payments should be characterized. Even in this context she did not state that all interest payments would be “on account of capital”. In both passages she refers to interest on borrowed funds used to produce income and in the second passage simply extends this by adding “from a business or property”.
35 In the current appeal we have been asked to consider directly the issue of when interest is deductible. The above review of the cases McLachlin J. relied upon in Shell indicates the important question is not whether the payment is a capital expenditure but whether it is “on account of capital”, a distinction that is explored further below. It also indicates that even the limited statement in Shell that all payments of interest on borrowed money used to produce income will be payments “on account of capital” is too broad. While this will usually be the result, each case requires an analysis of what the funds are to the borrower at the time of receipt.
36 To summarize, the decisions of this Court have not held that interest is always a capital expense, but have consistently found that when the proceeds of the loan add to the financial capital of the borrower any interest paid on that loan will be considered a payment “on account of capital”. This distinction becomes more important when one examines the tests used to characterize interest expenses in other jurisdictions, which is considered below.
(2) Does the Act Provide a Complete Code on the Deductibility of Interest?
37 I do not agree with Rothstein J.A. that the Act is a complete code on interest deductibility. The Minister submitted to this Court that the Act was a complete code for the deductibility of interest as interest payments can only be deducted if they meet the requirements of specific sections of the Act such as s. 8(1)(j) or s. 20(1)(c). It is evident from the manner in which the Canada Customs and Revenue Agency (now Canada Revenue Agency) allows moneylenders to deduct interest payments, without reliance on any specific section of the Act, when they are calculating profits for the purposes of determining their income for the year under s. 9 that they have not adhered to this position in the past. In circumstances where interest is not a payment “on account of capital”, it may be deducted as long as it meets the other requirements, such as those set out in s. 8(1)(f) or s. 18(1)(a), and is not precluded by some other section of the Act.
(3) What Test Should Be Used to Classify an Interest Payment for the Purposes of the Act?
38 There are a number of ways to characterize the payment of interest. The method adopted by Bowman A.C.J.T.C., which looked at the purpose the proceeds of the loan were being used for, is in accordance with general accounting principles and logic. In Steele v. Deputy Commissioner of Taxation (1999), 161 A.L.R. 201, the Australian High Court adopted a test that results in interest almost always being a current expense. In Wharf Properties, supra, the Privy Council adopted a test that looked at what the loan proceeds were being used for at the point in time when the interest was paid. While these tests are not all the same, they have one underlying feature that significantly reduces their application to determining the deductibility of interest in Canada. They are all concerned with determining whether each payment of interest is an “expenditure of a capital nature” (Wharf Properties, supra), or an “outgoing of a capital nature” (Steele, supra), neither of which answers the question which is relevant for Canadian purposes of whether it was a payment “on account of capital”. In attempting to determine if the expenditure or outgoing was of a capital nature, as required by the relevant statutes, other jurisdictions have looked to what the loan proceeds were spent on. Under the current wording in our Act this is not necessary, as we are only concerned with whether the payment is “on account of capital”.
39 Under our current Act it is not necessary to determine whether the payment is a capital expenditure but to determine whether the payment is being made “on account of capital”. This distinction in terms is particularly important in relation to interest payments, because loan proceeds are seldom retained in the form they are received, unlike other capital assets. This distinction means that under our Act it is only necessary to consider what the proceeds of the loan are to the borrower when they are received, and does not require an examination of what those loan proceeds are spent on. If the money adds to the financial capital then the payment of interest on that loan will be considered to be a payment “on account of capital”. If the loan proceeds constitute the inventory of the borrower, as is the case with moneylenders, then the payment of interest would be deductible. Lord Hoffmann in Wharf Properties, supra, discussed how loan proceeds can be different things to the borrower, at p. 339:
This decision does not seem to their Lordships to help Mr. Gardiner at all. It is directed to a different question, namely whether the sum borrowed constitutes an addition to the company’s capital or is a revenue receipt. In other words, it looks at the nature of the loan in the hands of the recipient rather than the question of whether a payment of interest is a capital or revenue expense. It is unusual for a loan of money to constitute a revenue receipt but this can be the case if borrowing money is “part of the ordinary day to day incidence of carrying on the business” (per Lord Templeman in the Beauchamp case, at p. 497) which may be the case in businesses of banking, financing or otherwise dealing in money: see Farmer v. Scottish North American Trust Ltd. [1912] A.C. 118. Ordinarily, however, a loan to a trading company, whatever the purpose for which it is intended to be used, will be an addition to that company’s capital. Mr. Gardiner did submit that the shortness of the successive terms of the loans in this case was enough to make them revenue receipts, but their Lordships do not agree. The borrowing did not form part of the company’s trading activities. While it or a replacement loan remained in place it was an addition to Wharf’s capital: compare European Investment Trust Co. Ltd. v. Jackson (1932) 18 T.C. 1. [Italics in original; underlining added.]
40 As earlier pointed out, loan proceeds are usually thought of as additions to the financial capital of the borrower. This view makes it necessary to deal briefly with the wording at the beginning of both s. 8(1)(f)(v) and s. 18(1)(b) that prohibits the deduction of “outlays . . . of capital”. A literal reading of this phrase could render every expenditure that could not be directly traced to revenue non-deductible as an outlay of capital. This has not been the approach under these sections in the past, and the analysis should continue to look at what is acquired rather than examining where the money to make the payment originates.
C. Costs
41 Under s. 18.25 of the Tax Court of Canada Act, the Minister must pay the reasonable and proper costs of the taxpayer when it seeks to judicially review a decision made under the informal procedure.
18.25 Where the Minister of National Revenue makes an application under section 28 of the Federal Court Act to review and set aside a judgment referred to in section 18.24, the reasonable and proper costs of the taxpayer in respect of the application shall be paid by Her Majesty in right of Canada.
The purpose of s. 18.25 is to ensure the Minister bears the costs of the appeal process once he begins it. Accordingly, the costs in the courts below are confirmed and the appellant is awarded his reasonable and proper costs in this Court.
VI. Conclusion
42 The Agreement to pay $100,000 to purchase accumulated goodwill and the agreement not to compete were made to create an enduring benefit for the appellant taxpayer Gifford and therefore the payment was “on account of capital”. The interest payment in this case, under current Canadian law, was also a payment “on account of capital”, because the funds, borrowed to make the payment to Bentley, themselves added to the financial capital of the appellant. As both payments in question were “on account of capital”, s. 8(1)(f)(v) prevents a deduction from being made for either expense. This appeal is dismissed. The reasonable and proper costs in this Court are to be paid to the appellant by the respondent. The costs awarded in the lower courts are upheld.
Appeal dismissed with costs.
Solicitors for the appellant: McMillan Binch, Toronto.
Solicitor for the respondent: Deputy Attorney General of Canada, Ottawa.
Solicitors for the intervener: Osler, Hoskin & Harcourt, Toronto.