Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.
Principal Issues: Is Interest deductible when the return is fixed at an amount that is less than the cost of borrowing ?
Position: Interest not deductible.
Reasons: Where borrowed money is used to acquire property (other than a preferred share) having a return lower than the interest rate on the borrowed money, it is the Department’s position that the interest expense is not deductible because there is no profit or reasonable expectation of profit and therefore the borrowed money was not used for the purpose of earning income from a business or property.
973247
XXXXXXXXXX C. Tremblay
Attention: XXXXXXXXXX
October 14, 1998
Dear Sirs:
Re: Interest Deductibility
This is in reply to your letter of December 9, 1997, requesting our opinion regarding the deductibility of interest in a hypothetical situation. We apologize for the long delay in responding to your letter.
You describe a situation where a corporate taxpayer who borrows $10,000,000 from an arm's length commercial lending institution at 6% uses the funds to buy a business asset and carry on business for a number of years. The asset is sold for $25,000,000 and the business is discontinued. The business loan is not repaid and the net proceeds of the sale (after taxes) of $20,000,000 is invested in income instruments (e.g. guaranteed investment certificates) paying interest at 4%.
The situation that is described appears to involve a series of actual completed transactions involving specific taxpayers; consequently, your questions should be directed to your taxation services office which has the responsibility of determining the tax consequences of completed transactions and their implications to the specific taxpayers. Although we are unable to provide any opinion in respect of the specific transactions described in your letter, we have set out some general comments which may be of some assistance.
It is the current use, rather than the original use of borrowed funds which is relevant in assessing the deductibility of interest payments pursuant to 20(1)(c) of the Act. Further to comments in Bronfman Trust v the Queen ( 87 DTC 5059) the statutory deduction requires a characterisation of the use of borrowed money as between the eligible use of earning non-exempt income from a business or property and a variety of possible non-eligible uses. The onus is on the taxpayer to trace the borrowed funds to an identifiable use which triggers the deduction. What is relevant is the taxpayer's purpose in using the borrowed money in a particular manner and the current and direct use of the borrowed money. It is well established in the jurisprudence that it is not the purpose of the borrowing itself which is relevant, what is relevant, rather, is the purpose in using the borrowed funds in a particular manner. In John Tennant v The Queen (96 DTC 6191), the court ruled that the basis for an interest deduction under paragraph 20(1)(c) of the Act is not the value of the replacement property but the amount of the original loan.
The current use must also be aimed at earning income. Accordingly, in the case at hand, the taxpayer must establish a link between the fixed income instruments, (the current eligible use property) the proceeds of disposal of his original business asset and the money that has been borrowed to acquire the original eligible use business asset.
It is our position that interest on borrowed money is not deductible if it was not an expense incurred for the purpose of earning income. No deduction is allowed for an expense except to the extent it was incurred by the taxpayer for the purpose or producing income from his property or business. Accordingly, if the money previously borrowed is not repaid and is not used for the purpose of earning income from a business or property, the investment income would be subject to income under 12(1)(c) or 12(3) of the Act, however, no deduction for the loan interest would be available pursuant to paragraph 20(1)(c) of the Act. Where borrowed money is used to acquire a property (other than a preferred share) having a return lower than the interest rate, it is the Department’s current position that the interest expense is not deductible because there is no profit or no reasonable expectation of profit.
We trust our comments will be of assistance to you
Yours truly,
for Director
Financial Industries Division
Income Tax Rulings and
Interpretations Division
Policy and Legislation Branch
