October 07, 2011

Her Majesty the Queen (Appellant) v. Sherway Centre Limited (Respondent)

98 DTC 6121
Federal Court of Appeal
February 5, 1998

(Court File No. A-741-96.)

Deductions — Interest — Corporate taxpayer issuing bonds at the below-market coupon rate of 9.75% per annum — Participatory interest on the bonds equal to 15% of the taxpayer’s “Operating Surplus” in excess of $2.9 million also payable annually — Whether such participatory interest deductible — Income Tax Act, R.S.C. 1985 (5th Supp.), c. 1, as amended, ss. 20(1)(c) and 20(1)(e).

To finance the construction of a large shopping centre, the corporate taxpayer had obtained interim bank loans which later required long-term refinancing. Accordingly, at a time when the prevailing market interest rate was 10.25% per annum, the corporate taxpayer issued bonds at the below-market coupon rate of 9.75% per annum. Participatory interest on the bonds (equal to 15% of the taxpayer’s “Operating Surplus” in excess of $2.9 million) was also payable annually. In assessing the taxpayer for 1987 and 1988, the Minister disallowed the deduction by it of the said participatory interest payments. In allowing the taxpayer’s appeal (96 DTC 1640), the Tax Court of Canada found that the participatory interest was designed to increase the overall yield to the bondholders from 9.75% to a projected level of approximately 10.25%. Then, applying M.N.R. v. Yonge-Eglinton Building Limited (1974), FCA, the Tax Court went on to allow the participatory interest payment deductions under paragraph 20(1)(e) of the Act (as interest on money borrowed to earn income from a business). The Crown appealed to the Federal Court of Appeal.

Held: The Crown’s appeal was dismissed. The Tax Court Judge ought to have allowed the deduction under both paragraphs 20(1)(c), and 20(1)(e) of the Act. In A.G. of Ontario v. Barfried Enterprises, the Supreme Court of Canada held that one of the essential characteristics of interest is that it accrues daily. In Re Balaji Apartments Limited v. Manufacturers Life Insurance Company, the Ontario High Court held that, to be interest, a payment must be a percentage of the principle sum. In the present taxpayer’s case, the appropriate interpretation to be given to the daily accrual of interest requirement (in the Barfried case) was that each holder’s entitlement to interest had to be capable of ascertainment on a daily basis. Furthermore, the Balaji Apartments’ case had to be limited to facts similar to those on which it had been decided. Applying these principles, the participatory interest in the present taxpayer’s case was based on a percentage of its Operating Surplus, and was thus capable of being allocated on a day-to-day basis. Such participatory interest was also capable of being characterized as a percentage of, or in some way related to, the principle sum, because it was payable only so long as there was principle outstanding. The participatory interest had also been paid to ensure a 10.25% effective interest rate. Finally, to disallow the deduction of the participatory interest payments in this case under paragraph 20(1)(c) of the Act would be tantamount to ignoring the new commercial realities not considered by the courts in past decisions. For all of these reasons, the participatory interest was deductible under paragraph 20(1)(c) of the Act, as well as under paragraph 20(1)(e). The Minister was ordered to reassess accordingly.