16 July 2002 External T.I. 2002-0142475 - INTEREST DEDUCTIBILITY INCOME TRUST

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:

Individual borrows money to invest in an income trust. Trust makes a distribution to individual which includes a return of capital. The return of capital is used for personal use. Is the interest related to the return of capital still deductible under paragraph 20(1)(c)?

Position TAKEN: No.

Reasons FOR POSITION TAKEN:

With respect to the return of capital from the income trust to the individual, the current use of that portion (the return of capital) of the borrowed funds is for personal use and therefore, any interest relating to borrowed money used for personal use is not deductible under paragraph 20(1)(c). See 9511817, 9326621, 9726133, 2001-0081025, 2001-0110455,

XXXXXXXXXX 2002-014247
G. Moore
July 16, 2002

Dear XXXXXXXXXX:

Re: Interest Deductibility

This is in reply to your letter of May 21, 2002, regarding interest deductibility with respect to money borrowed to invest in an income trust.

You are asking for our views in the following example. An individual borrows $10,000 at 4% interest and invests it in an income trust. In the first year, the individual incurs interest of $400 on the borrowed money and receives distributions of $1,400 in cash from the income trust. This distribution is shown as $500 of "other income" on a T3 information slip and $900 is a return of capital. The individual uses the $1,400 for personal use. The individual reports $500 of other income and claims a deduction of $400 for investment carrying charges. You are enquiring as to whether the full amount of the interest on the borrowed money is deductible and if it is not, which portion is not deductible. If the individual has sold the investment, the proceeds need to be invested in another investment to maintain the deductibility of interest. In this case, the taxpayer has not sold the investment, just received distributions from it.

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.

Interest on borrowed funds is deductible for purposes of the Income Tax Act (the "Act") if it meets all the requirements of paragraph 20(1)(c) of the Act. Paragraph 20(1)(c) of the Act provides notably that the money must have been borrowed for the purpose of gaining or producing income from a business or property. It is the current use made of the borrowed funds in a particular year rather than the initial use of the funds which must be considered in determining whether the interest paid or payable with respect to the borrowed funds is deductible in the particular year. In order to determine whether borrowed funds have been put to an eligible use, it is necessary to determine the current use of the original borrowed funds.

We would draw your attention to our response to Q.18 at the 1984 Canadian Tax Foundation Revenue Canada Round Table, in which we stated:

"It is the Department's position, supported by several cases, including Trans-Prairie Pipelines Ltd. v. MNR, 70 DTC 6351, that interest sought to be deducted under paragraph 20(1)(c) of the Act must relate to a business or property income source. This requirement will not be satisfied in circumstances where the income source ceases to exist, is transferred, or changes use (for example, where a rental property becomes the owner's personal residence). Where one income source is disposed of and the proceeds are used to acquire another income source, interest on the borrowed money that was used to acquire the first income source will continue to be deductible to the extent that the borrowing is reflected in the cost of the new income source."

This position has been confirmed numerous times over the years. For example, refer to our response to Q.20 at the 1987 Corporate Management Tax Conference Report. Also note the Supreme Court of Canada decision in The Queen v. Phyllis Barbara Bronfman Trust, 87 DTC 5059, where it was confirmed that it is the current use made of the borrowed funds in a particular year, rather than the initial use of the funds, which must be considered in determining whether the interest paid or payable with respect to the borrowed funds is deductible in a particular year.

In the hypothetical situation you described, it is not clear when during the first year of investment that the capital was returned to the investor. We are assuming for the purposes of this example that the capital was not returned to the investor until the end of the first year. Accordingly, given this assumption, the current use of the borrowed money would be considered for income earning purposes for the entire duration of the first year and the related interest would generally be deductible provided all of the requirements of paragraph 20(1)(c) of the Act are met. For the second year of the investment, it is our view that the interest on that portion of the borrowed money that relates to the return of capital from the income trust would not be deductible since its current use is personal and not for an income earning purpose. Therefore, assuming that the total interest expense incurred for the second year is $400, it is our view that interest of $36 ($900/$10,000 X $400 = $36) would not be deductible for the second year pursuant to paragraph 20(1)(c) of the Act since $900 of the original investment of $10,000 is no longer being used for income earning purposes.

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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