3 October 2000 Internal T.I. 2000-0038717 - 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:

1. Existence of reasonable expectation of profit

2. If borrowed money cannot be traced to eligible use can interest deductibility be determined by allocating funds between eligible and ineligible uses?

3. Was interest payable pursuant to a legal obligation when obligation arose only on the last day of the year?

4. Does 18(4) apply only in respect of the portion of a debt that is interest bearing or to the entire debt?

Position:

1. Probably.

2. Yes
3. No
4. To the whole debt

Reasons:

1. The business being carried on is a commercial venture with no personal element. Insufficient

information was provided to support a finding that there was no REOP.

2. Reasonable approach to settle file.

3. Liability for interest was created at end of year. Respectable argument can be made that interest

prior to this time did not accrue pursuant to a legal obligation.

4. Wording of definition of in 18(5).

		October 3, 2000

	VANCOUVER TSO	HEADQUARTERS
	Section 442 - 21, SC 04	C. Savage
(613) 957-8957
	Attention: Larry Moi
		2000-003871

Interest Deductibility

This is in reply to your memorandum of July 17, 2000, requesting our comments concerning the deduction of interest to a situation currently under audit.

XXXXXXXXXX

You feel that the interest expense in respect of the $XXXXXXXXXX loan from GCO should be disallowed for the following reasons:

1. with respect to ACO's investment in the XXXXXXXXXX joint venture, there is no source of income based on your conclusion that there is no reasonable expectation of profit;

2. the taxpayer has failed to prove conclusively by tracing that the borrowed money was used for the purpose of earning income; and

3. for the XXXXXXXXXX taxation year there was no legal obligation to pay interest. Alternatively, a portion may be allowed in respect of the XXXXXXXXXX investment but restricted under the provisions of subsection 18(4) of the Act.

The taxpayers representative has stated that at no point in time were any borrowed funds ever invested in any business or other property investment which was not of a business or income producing nature. While the investment may not have been the most prudent one, in hindsight, there is absolutely no basis for the conclusions you have made. With respect to tracing they have noted that you attempted to notionally allocate portions of the indebtedness on some kind of apportioned basis but that your apportionment is completely devoid of any factual basis of tracing and therefor is without merit.

Our Comments

1. No reasonable expectation of profit with respect to the XXXXXXXXXX joint venture.

The reasonable expectation of profit test has been dealt with by the courts in numerous recent decisions. One such case was the 1999 Federal Court of Appeal decision in Spire Freezers Ltd. The following remarks of Robertson, J.A. in that decision in our view provide an accurate summary of the state of the law in this area:

[49]" Generally speaking, the reasonable expectation of profit doctrine is intended to deny tax benefits where profit-seeking becomes the pursuit of an "impossible dream" or there is an overriding personal element attached to an undertaking. That personal element usually manifests itself as a blatant indifference to the profitability of what might otherwise be considered a genuine business undertaking. The classic example is the hobby farmer who makes his money in the city as a lawyer or physician, and then loses it in the country. In addition, there are those who are intent upon deducting half of the interest accruing on their home mortgage from their employment income on the ground that they incurred a rental loss with respect to a basement apartment which, according to the taxpayer's calculations, is as valuable as the upstairs premises.

[50] There are several factors set out in the jurisprudence which must be examined when assessing whether a reasonable expectation of profit is present, including: the personal element; the profit and loss experience in past years; the formulation of a proper business plan; the taxpayer's qualifications, training and experience; and the amount of time devoted to the enterprise. .... The reasonable expectation of profit doctrine is intended only to determine whether a business exists. "

As stated in this excerpt, the profit and loss experience is a factor in assessing whether a reasonable expectation of profit is present. However, it is not the sole factor. Based on the information you have given us, we are not persuaded that a reasonable argument can be made that ACO did not have a reasonable expectation of profit from its investment in the XXXXXXXXXX. It would be quite unusual to acquire a XXXXXXXXXX% interest in XXXXXXXXXX for any reason other than an expectation of profit. As the taxpayer's representative stated, the investment may not have been the most prudent one, in hindsight, but this is not sufficient to support a finding that there was no expectation of profit from the ownership and operation of the XXXXXXXXXX.

You have suggested in paragraph 3.2 of your memo, that ACO might have had a capital gain motive for its original acquisition of its interest in the XXXXXXXXXX and its continued operation of the XXXXXXXXXX. Unless this was the sole motive in acquiring and continuing to hold the XXXXXXXXXX, this fact, in our opinion, would not be sufficient basis to disallow the interest expense. In the acquisition of most if not all investments, prudent investors would have in mind the possibility of a disposition of the investments at a profit. However, as long as there existed a reasonable expectation of earning income from the holding of the investment, the expectation of possibly realizing a capital gain on its disposition would not preclude a deduction of interest under paragraph 20(1)(c).

In summary, while we cannot say that ACO meets the reasonable expectation of profit test with respect to its investment in the XXXXXXXXXX, given the information that you have provided we cannot support a contrary conclusion.

2. Tracing of borrowed funds

Paragraph 20(1)(c) allows a deduction for interest paid or payable pursuant to a legal obligation to pay interest on; borrowed money that is used for the purpose of earning income from a business or property or; an amount payable for property acquired for the purpose of gaining or producing income from the property or from a business; or a reasonable amount in respect thereof, whichever is less. For interest to be deductible under paragraph 20(1)(c), the courts have consistently held that the borrowed funds must be traced to a current eligible direct use. The phrase "or a reasonable amount in respect thereof" in 20(1)(c) should not be interpreted to support a reasonable allocation of interest between eligible and ineligible uses. These words refer to the reasonableness of the amount of the interest on the borrowed money rather than referring to a reasonable allocation of debt between eligible and ineligible uses.

It appears that borrowed funds were used by ACO for a number of uses. If you have determined that ACO does have some investments that would constitute ineligible investments for purposes of paragraph 20(1)(c), and ACO cannot satisfy you that they were acquired with funds other than borrowed funds, ACO should be required to identify the uses to which the borrowed funds were put. If this cannot be done, your suggestion that an allocation be made of the debts between eligible and ineligible uses may be a reasonable alternative to resolve the file.

3. Obligation to pay interest for XXXXXXXXXX/subsection 18(4)

A letter dated XXXXXXXXXX was signed by both ACO and GCO with respect to the loan between ACO and GCO. The letter states that the purpose of the letter is to "record our agreement with respect to the inter-corporate demand loan owing from you [ACO] to us [GCO]." The letter states that interest will be calculated yearly from the first day of each Taxation Year commencing XXXXXXXXXX.

You propose to disallow the interest claimed for the year ending XXXXXXXXXX on the basis that the legal obligation to pay interest was not established to have commenced on XXXXXXXXXX, the first day of the taxation year.

To be deductible under paragraph 20(1)(c), interest must be paid or payable pursuant to a legal obligation to pay interest. In our view, a respectable argument can be made that the letter signed on XXXXXXXXXX is not evidence that a legal obligation to pay interest existed throughout the year. Assuming that an agreement to that effect was not entered into at an earlier date such that the obligation only arose on XXXXXXXXXX, interest for the entire XXXXXXXXXX taxation year would not have been accruing pursuant to a legal obligation to pay interest. This situation can be distinguished from that dealt with by the Federal Court in the case of Mid-West Abrasive Co. [73DTC5429]. In that case, although interest was only payable if requested the debtor assumed liability for interest and committed itself in respect of interest when it signed and delivered the notes. In the situation you are reviewing, it appears that liability to pay interest did not arise prior to XXXXXXXXXX.

Subsection 18(4) may limit the amount of interest otherwise deductible on outstanding debts to specified non-residents. We agree with your view that the amount of the debt to be included under subparagraph 18(4)(a)(i) is the total amount of a particular debt not just the portion of the debt that is interest bearing. The definition of outstanding debts to specified non-residents found in subsection 18(5) include debts "on which any amount in respect of interest paid or payable by the corporation is, or would be, but for subsection (4), deductible in computing the corporation's income for the year"

Subsection 18(6) could not apply to ACO in respect of funds loaned to ACO by GCO which are then loaned by ACO to an affiliate. Subsection 18(6) could only apply if GCO makes a loan to another person who then makes a loan to ACO. It could, however, apply to the affiliate.

If you would like to discuss these issues further, please do not hesitate to call.

for Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch

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