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This translation was prepared by Tax Interpretations Inc. The CRA did not issue this document in the language in which it now appears, and is not responsible for any errors in its translation that might impact a reader’s understanding of it or the position(s) taken therein. See also the general Disclaimer below.
Principal Issues: [TaxInterpretations translation]
Deductibility of interest on a loan used to invest in mutual fund units, in a situation where this source of income has been disposed of, in part, and the proceeds of the sale have been used for personal purposes.
Position: Non-deductible loan interest on the portion used for personal purposes.
Reasons: Corporate Management Tax Conference 1987 and criteria set out in Bronfman 87 DTC 5059.
March 5, 2001
L'Outaouais Tax Services Office
Financial Industries Division
Attention: Nathalie Joncas
A. St-Amour, CA2000-004035
Interest deductibility
This is further to your memo received on August 1, 2000, requesting our opinion on the deductibility of interest on a loan used to invest in mutual fund units.
THE FACTS:
1. Mr. X borrowed $100,000 to invest in mutual fund units as follows:
Fund A: $50,000 25,000 units at $2.00
Fund B: $50,000 50,000 units at $1.00
2. In 19X1, the annual income from the two funds was reinvested in additional units: 2,000 units of Fund A and 5,000 units of Fund B at a unit cost of $3 and $1.75 respectively.
3. In 19X2, Mr. X sold 2,500 units of Fund A and all the units of Fund B for a unit sale price of $5 and $1.50 respectively. Mr. X did not repay the $100,000 loan but used the proceeds from the sale of the units for personal expenses.
4. Mr. X deducted the interest on the $100,000 loan on his 19X2 tax return.
QUESTION:
Is the interest on the $100,000 loan deductible in 19X2?
YOUR POSITION:
You are of the view that part of the interest on the loan used to acquire Fund A is not deductible in 19X2 since some of the units have been sold. You propose three different methods for calculating the portion of the loan that must be taken into account for paragraph 20(1)(c) purposes. Briefly, the methods you have suggested are as follows:
a) 9.25% of the units have been sold (2,500 out of 27,000). In your calculation, you take into account all the units before the sale. Therefore, only the interest on $45,375 (90.75% x $50,000) would be deductible.
b) 10% of the units have been sold (2,500 out of 25,000). You do not take into account the units acquired in 19X1. Therefore, only the interest on $45,000 (90% x $50,000) would be deductible.
c) 2% of the units were sold (500 out of 25,000). Using this method, he could claim interest on $49,000 (98% x $50,000).
You favour the calculation method in a) above because, in your opinion, the debt should be reduced by taking into account the units sold out of the total units held before the sale.
You are of the opinion that the interest on the portion of the loan that was used to purchase the units of Fund B is not deductible because the source of income no longer exists.
Position of the Taxpayer:
Mr. X states that he can continue to deduct interest even though he has disposed of Fund B and part of Fund A. In his view, he can continue to deduct interest because the market value of his investment in Fund A exceeds the total principal amount of the loan. The market value of his units in Fund A was $122,500 at the time of the disposition in 19X2 (24,500 x $5.00).
Paragraph 20(1)(c) allows a deduction in computing income for a taxation year for interest paid in the year or payable in respect of the year (depending on the method regularly followed by the taxpayer in computing the taxpayer’s income), pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from a business or property (other than borrowed money used to acquire property the income from which would be exempt or to acquire a life insurance policy).
The question of whether mutual fund units were acquired for the purpose of earning income is a question of fact that can only be determined after a review of all the relevant facts. That determination must be made annually. In Bronfman 87 DTC 5059, Justice Dickson of the Supreme Court of Canada set out the following tests for interest deductibility:
Not all borrowing expenses are deductible. Interest on borrowed money used to produce tax exempt income is not deductible. Interest on borrowed money used to buy life insurance policies is not deductible. Interest on borrowings used for non-income earning purposes, such as personal consumption or the making of capital gains is similarly not deductible. The statutory deduction thus requires a characterization 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 ineligible uses. The onus is on the taxpayer to trace the borrowed funds to an identifiable use which triggers the deduction. Therefore, if the taxpayer commingles funds used for a variety of purposes only some of which are eligible he or she may be unable to claim the deduction … .
The interest deduction provision requires not only a characterization of the use of borrowed funds, but also a characterization of “purpose”. Eligibility for the deduction is contingent on the use of borrowed money for the purpose of earning income. It is well established in the jurisprudence, however, that it is not the purpose of the borrowing itself which is relevant. What is relevant, rather, is the taxpayer's purpose in using the borrowed money in a particular manner … . Consequently, the focus of the inquiry must be centred on the use to which the taxpayer put the borrowed funds.
… [I]t is the current use rather than the original use of borrowed funds by the taxpayer which is relevant in assessing deductibility of interest payments… .
For an expense to be deductible, it is therefore necessary to trace the use of the borrowed funds to a source of income from a business or property. As stated in Question 22 of the 1987 Corporate Management Tax Conference, it is our opinion that there is no source of income in circumstances where the facts show that property, acquired for the purpose of earning income, is disposed of in part, and the proceeds are used by the taxpayer for personal expenses; interest on borrowed money used to acquire the original source of income will not continue to be deductible on that portion.
However, the value of property acquired with borrowed money is not relevant for interest deductibility purposes. For example, in a situation where an acquired property declines in value, the interest on the borrowed money could continue to be deductible as long as the source of income is not disposed of and all the other conditions stipulated in paragraph 20(1)(c) are satisfied. Conversely, an increase in the value of a property does not result in a new source of income.
In the situation you described, the source of income, Fund B, acquired with part of the loan, was disposed of and the proceeds used for personal purposes. As stated above by the Supreme Court in Bronfman, this is an impermissible use of a loan. Consequently, the interest on that portion of the loan will cease to be deductible when the units are disposed of. We agree with you that the interest on the portion of the loan used to acquire the units of Fund B will cease to be deductible when the units are disposed of since the borrowed money ceases, at that time, to be used to earn income from property.
According to the facts you described, 2,500 units of Fund A were also disposed of and the proceeds used for personal purposes. You asked us what method should be used to calculate the number of units sold in order to determine the source of income remaining after that disposition. We are of the view that, due to the fungible nature of mutual fund units, the Agency generally recommends the proration method. Since specific units cannot be identified, the LIFO (specific identification) method and the FIFO method are generally not applicable to identical property such as mutual fund units.
The eligible source of income under this recommended method is computed as follows:
The 2,500 units sold must be allocated to the two acquisition tranches
25,000/27000 x 2,500 = 2,315 units purchased in 19X1
2,000/27,000 x 2,500 = 185 units purchased in 19X2
27 000
This leaves only 90.74% (22,685/25,000) of the original source of income. Consequently, using this method, the interest on the $50,000 loan to acquire the units of Fund A will continue to be deductible on an amount of $45,370 ($50,000 x 90.74%), after the disposition of the units, provided that all the conditions stipulated in paragraph 20(1)(c) are otherwise satisfied.
We would also like to point out that a simple increase in a subsequent year in the number of units, for example, up to 25,000 units, will not make the interest deductible again on that portion of the loan.
If you have any further questions, please do not hesitate to contact A. St-Amour at 952-1764.
ACCESS TO INFORMATION
For your information, a copy of this memorandum will be severed using the Access to Information Act and will be available in the Legislative Access Database (LAD) located on the mainframe of the Canada Customs and Revenue Agency. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, the Legislative Access Bank version can be provided. Alternatively, the client may request a severed copy using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Ms. Jackie Page at (819) 994-2898. A copy that has been severed in accordance with the Privacy Act will be sent to you for delivery to the client.
Manager
Financing and Plans Section
Financial Industries Division
Income Tax Rulings Directorate
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