7 December 1999 Income Tax Severed Letter 1999-0014010 - INTEREST DEDUCTIBILITY

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

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: interest deductibility after Ludco

Position: Ludco reasoning is confined to those particular facts

Reasons:

X Interest Deductibility

The Federal Court of Appeal recently decided Ludco Enterprises Ltd. V. The Queen, 99 DTC 5153 and John R. Singleton v. The Queen 99 DTC 5362. Both decisions relate to the interpretation of paragraph 20(1)(c) of the Act, but express divergent opinions on whether the legal form or economic substance of a taxpayer's transactions are controlling for purposes of determining the deductibility of interest.

In Ludco, the corporate taxpayer invested in companies structured to accumulate capital gains in a tax haven. Initially, the corporations the taxpayer invested in adopted a "no dividend" policy; eventually, however, nominal dividends were paid to the taxpayer-investor. The trial judge found that the taxpayer's purpose for the borrowing was to acquire shares in investment companies. The investment companies, moreover, were found to be organized for the purposes of (1) avoiding or postponing the payment of taxes and (2) converting at least half of the taxable income from the "business" activities into capital gains. The Court of Appeal accepted the trial judge's findings of fact, upholding the denial of the taxpayer's interest deduction. Since corporate taxpayers routinely make common share equity investments in ventures (in both arm's length and non-arm's length companies) where no immediate return of income is likely, will Revenue Canada provide its views about whether an interest deduction in such cases is jeopardized under Ludco?

In Singleton, an individual withdrew $300,000 from his law firm partnership capital account and used the proceeds to finance the purchase of a home registered in his wife's name. On the same day, the taxpayer borrowed substantially the same sum and contributed it to the law firm's capital account. The court ruled that the interest payable on the borrowed money was deductible because the direct or immediate use of the borrowed funds was for the purpose of "earning income". What is Revenue Canada's view of this decision? Can individual taxpayers borrow funds and obtain interest deduction on the borrowing where the purpose is to invest in a mutual fund with a stated investment policy objective of "capital appreciation"? Alternatively, can companies secure deductions on debt where the purpose of the borrowing is to invest in companies that will require reinvestment of future earnings in the business for a significant, even, indefinite, period of time?

Response

Leave to the Supreme Court has been sought in both Ludco and Singleton thus our comments on these cases are somewhat constrained.

In our view, the issue in Singleton is quite different than that in Ludco. In Singleton, the taxpayer carried out several transactions the overall effect of which was to obtain an interest deduction on the purchase of a home. The majority of the FCA rejected our argument that the purpose test in 20(1)(c) is the true or ultimate purpose of the transactions. Instead, they found that each transaction must be viewed independently. Since the funds borrowed by Mr. Singleton were contributed to the law firm for use in its business, the borrowed money was used by Mr. Singleton for the purpose of earning income. In Ludco, the courts were not dealing with connected transactions. There was only one transaction. Funds were borrowed to buy shares. The only issue is whether those shares were acquired for the purpose of earning income.

The Ludco situation involved facts that are quite different than the usual share investment. The companies in which Ludco invested were structured solely for tax purposes. They were designed for tax deferral and income transformation. They were incorporated in jurisdictions that did not tax their accumulating income. It would be unusual for these facts to be present in the normal share investment of either a public or private company or units of a mutual fund.

In our view, normal investments are fundamentally different than those present in the Ludco situation as the degree of certainty of the investment results to be obtained that was present there does not usually exist.

As stated by Marceau J.A., "... it will very seldom be the case that in choosing a particular investment (an investor's( purpose is precisely to reduce as much as possible, and even refuse, so to speak, the income that the investment is likely to produce."

Thus, the Ludco decision will not affect our position on interest deductibility.

Chris Savage
December 7, 1999