October 07, 2011

Frederick W. Hill (Appellant) v. Her Majesty the Queen (Respondent)

Tax Court of Canada
2002 DTC 1749
April 30, 2002

(Court File No. 2000-3636(IT)G.)

Deductions — Interest — Taxpayer and others acquiring land in Calgary for the purpose of building an office building — Taxpayers selling the land, taking back possession thereof by way of lease, and borrowing from the purchaser substantial amounts secured by mortgage — Whether certain formula-driven “excess interest” payments in respect of the said mortgage deductible — Whether Minister’s reassessments denying the deductibility of the said payments based on such factors as: (a) an allegation that the said payments made in respect of contingent liabilities; (b) an alleged governmental policy prohibiting the deduction of compound interest; (c) the REOP doctrine; and (d) the GAAR, justified — Income Tax Act, R.S.C. 1985 (5th Supp.), c. 1, as amended, ss. 20(1)(c), 80(2)(b), 245(1), 245(2), 245(3) and 245(4).

The taxpayer (to the extent of 25%) and others (collectively referred to as the “Co-owners”) acquired land in Calgary for the purpose of building thereon an office building (“the Project”). The Co-owners, including the taxpayer, immediately sold the land to certain trustees of a superannuation plan (“POSS”) which was replaced by a corporation referred to as “Postel”. Postel leased the land back to the Co-Owners for a 99-year term, and lent them $17,450,000 to erect an office building on the land. Such loan was secured by a 99-year mortgage on the property. Under the said leaseback agreement, after the building was completed, 40.5692% of the cash flow from the Project was initially to go to the co-owners. The remaining 59.4308% of the cash flow (defined as the “Balance of net Cash Flow”) was to be paid to POSS as interest or as rent. If the mortgage interest expense on any payment date were to exceed the Balance of net Cash Flow, such excess was to be paid to the mortgagee (POSS) as interest. If the converse were the case, the excess of the Balance of net Cash Flow (over the mortgage interest expense) was to be paid to POSS as rent. During the period from 1974 to 1999, with the exception of 1983, no lease payments were required to be made, as the Balance of net Cash Flow from the building was not sufficient to trigger these. On December 22, 1983, HDL (a corporation owned to the extent of 25% by the taxpayer) purchased the interests in the lease and assumed the obligations under the mortgage, borrowing a further $7,550,000 from Postel to do so. At that time, the various agreements were amended to reflect changes in certain interest rates, and in the cash flow split percentages. Cash payments received by the taxpayer over the period from 1975 to 2001 were included in his income, but because of his interest expense, he reported no net profits for tax purposes. In reassessing the taxpayer for 1996 and 1997, the Minister disallowed the deduction of interest expenses which he had claimed. The deduction of non-capital losses from 1992 and 1993 (relating to the interest expenses from those years) which had been claimed by the taxpayer for 1996 was also disallowed. The taxpayer appealed to the Tax Court of Canada.

Held: The taxpayer’s appeal was allowed. Prior to trial, the parties agreed that the issues were those set out in the following headings. ISSUE 1: Were the excess interest amounts in 1992, 1993, 1996 and 1997 amounts payable in those years, or were they contingent liabilities? On December 31 of each year, the mortgagee (Postel) could sue for its excess interest, based on the wording of the relevant agreements. This right was not affected by the fact that Postel was obligated to lend funds to the taxpayer to enable him to pay it the excess interest in issue. As for the contingent liability issue, the House of Lords defined a contingency to be an event which may or may not occur, and a contingent liability to be a liability depending for its existence upon an event which may or may not happen (see Winter et al. v. IRC). In the case at bar, the taxpayer’s liability to pay the mortgagee the excess interest was not contingent on any future event. If the property values did not increase significantly, the mortgage had contractually bound itself to accepting less than the outstanding indebtedness by simply taking the property back. However, there always existed a liability which did not depend on the vagaries of the Alberta real property market for its very existence. ISSUE 2: Did the transactions in December 1995 constitute payment of interest and the borrowing of a like amount as principal, resulting in the excess interest in 1996 and 1997 being simple interest as opposed to compound interest? Postel obliged itself to lend the taxpayer, on request, an amount equal to any amount of excess interest paid by the taxpayer to Postel. This happened in the December 31, 1995 transactions. The taxpayer arranged for his funds (some $60 million) by way of loan from a chartered bank, and Postel came up with its $60 million, although there was no evidence of how it did this. This constituted payment by the taxpayer of the accrued excess interest, so that the excess interest in 1996 and 1997 was not compound interest (i.e., interest on accrued interest), but simple interest, which was deductible. ISSUE 3: Did the taxpayer’s investment in the Project have a reasonable expectation of profit (“REOP” )? By applying the REOP test, the Minister concluded that the operation of a multi-million dollar office building over a lengthy period of time did not constitute a business for tax purposes. A business, however, existed, as could be seen from such things as the time spent, the capital invested, the organizational structure, the Co-owners’ behaviour, the lack of a personal element, and the maintenance of books and records. On a balance of probabilities, therefore, the Minister did not show that the taxpayer had no REOP. ISSUE 4: Did the GAAR apply to permit the Minister to ignore the purported payment of interest in 1995 and the borrowing of a like amount of principal? Applying the tests set forth by Rothstein, J.A. of the Federal Court of Appeal in the OSFC case, the inexorable conclusion was that the 1995 transactions referred to were avoidance transactions within the meaning of subsection 245(3) of the Act. However, they were saved from the GAAR by virtue of the fact that they were not avoidance transactions resulting in a misuse or abuse of the provisions of the Act (see subsection 245(4) of the Act). In addition, the Minister did not produce any materials which would assist in understanding the government’s policy in permitting the deduction of simple interest on a payable basis, while not permitting the deduction of compound interest on a paid basis. In light of the foregoing findings, the taxpayer was entitled to the interest deductions being sought for 1995 and 1996, and to the deduction for 1996 of the non-capital losses being sought, as well. The Minister was ordered to reassess accordingly.