9 October 2002 External T.I. 2001-0084055 - 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 CCRA.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.

Principal Issues:

Interest deductibility on mortgage interest and on income-earning investments

Position TAKEN: General comments given.

Reasons FOR POSITION TAKEN:

The direct use of borrowed funds is the test that predominates in determining the deductibility of interest. See 2000-001735, 2000-0042655, 2002-012419, 2002-0126217, 9823830

XXXXXXXXXX        2001-008405
G. Moore
October 9, 2002

Dear XXXXXXXXXX:

Re: Interest Deductibility

This is in reply to your letter of May 11, 2002, wherein you requested our opinion on the subject of interest deductibility. In particular, you asked the following two questions:

1. You own an investment portfolio including interest-carrying investments with a market value of $200,000. At the same time, you have a mortgage on your principal residence in the amount of $100,000. Your bank offered you a collateral line of credit to replace the mortgage. You are considering selling $100,000 of your investments and using the proceeds to pay off your line of credit. You would then re-establish your line of credit for $100,000 and buy the same or other interest or dividend paying investments. Alternatively, you could accept a line of credit and not sell any of your investments. You are asking if you could deduct the interest expense on the line of credit in the first and second scenarios.

2. What is the Canada Customs and Revenue Agency's policy on interest deductibility in respect of money borrowed to acquire share capital?

Our Comments

Written confirmation of the tax implications inherent in particular transactions are given by this Directorate only where the transactions are proposed and are the subject of an advance income tax ruling request submitted in a manner set out in Information Circular 70-6R5. As stated in paragraph 22 of Information Circular 70-6R5, written opinions are not advance tax rulings and, accordingly, are not binding on the Agency. The following comments are, therefore, of a general nature only.

1. Paragraph 20(1)(c) of the Income Tax Act governs the deductibility of interest expense for income tax purposes and, generally, that provision limits the deduction to interest on borrowed money which is used for the purpose of earning income from a business or from property. In other words, it is the direct use to which the borrowed money is applied which governs whether the interest is deductible for tax purposes.

The Supreme Court of Canada has stated that the onus is on the taxpayer to trace funds to a current eligible use (Bronfman Trust). When borrowed money is directly applied to a given use, its use is readily determined. Recent decisions of the Supreme Court have introduced the concept of linking borrowed money, rather than tracing it, to its use, as well as approving of a flexible approach to tracing/linking (Tennant, Shell, Ludco, Singleton). In this context, a practical approach can be used to determining the use of borrowed money and its redeployments.

In the first scenario you described, an individual owns an investment portfolio including interest-carrying investments with a market value of $200,000. At the same time, the individual has a mortgage of $100,000 on his principal residence and will replace the mortgage with a line of credit. The individual will sell $100,000 of his investments and use the proceeds to pay off the line of credit. The individual would then re-establish the line of credit for $100,000 and buy the same or other interest or dividend paying investments. In this scenario, the individual would generally be able to trace/link the borrowed money to the direct, income-earning use to which it is applied. In the second scenario, an individual would replace the mortgage of $100,000 on a personal residence with a line of credit for $100,000 and not sell any of his investments. In this scenario, in our view, there is no link between the borrowed money and a direct income earning use (income-earning securities).

2. With respect to your question as to whether interest expense would be deductible if it relates to investments that appreciate in value (i.e., gains) rather than pay interest or dividends, we have the following comments.

With respect to borrowing money to acquire common shares, the primary issue is the income earning purpose of the share acquisition. The Supreme Court has indicated in the Ludco case that the purpose test in paragraph 20(1)(c) is to be applied as follows: considering all the circumstances, did the taxpayer have a reasonable expectation of income at the time the investment was made (absent a sham, window dressing or other vitiating circumstances). Normally, we consider interest costs in respect of funds to purchase common shares to be deductible on the basis that there is a reasonable expectation (at the time the shares are acquired) that the common shareholder will receive dividends. However, it is conceivable that in certain fact situations, such reasonable expectation would not be present. Where evidence from corporate officials indicates that dividends are not expected to be paid and that shareholders are required to sell their shares in order to realize their value, the purpose test would likely not be met. Where a corporation is silent with respect to its dividend policy, or where the dividend policy is that dividends will be paid when operational circumstances permit, the purpose test will likely be met. However, each situation must be dealt with on the basis of the particular facts involved. The foregoing comments are also generally applicable to investments in mutual funds and mutual fund corporations.

We trust that the foregoing will be useful.

Yours truly,

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

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