10 April 2003 External T.I. 2002-0147295 - COMPOUND INTEREST

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:

Whether subsection 10(1.1) and paragraph 18(3.1)(b) apply to accrued but unpaid compound interest in 18(2) or 18(3.1) circumstances

Position: No

Reasons: Wording of legislation

		2002-014729
XXXXXXXXXX 	Denise Dalphy, LL.B.
(613) 941-1722
April 10, 2003

Dear XXXXXXXXXX:

Re: Compound Interest

We are writing in reply to your letter dated June 12, 2002 wherein you requested technical interpretations with respect to subsections 18(2) and (3.1) and paragraph 20(1)(d) of the Income Tax Act (the "Act") and compound interest.

The situations that you have asked us to consider are as follows:

Scenario #1

1. The taxpayer's principal business is the purchase and sale of land.

2. The taxpayer purchased vacant land, which was largely financed with debt.

3. The land represents inventory to the taxpayer.

4. The terms of the loan provide that interest at a commercial rate will accrue annually and be repaid on maturity of the loan together with the principal.

5. The loan provides for simple and compound interest to be repaid on the maturity date of the loan.

6. The land may be sold before or after the maturity date of the loan.

Scenario #2

1. The taxpayer is constructing a condominium that will be strata titled and whose units will be sold to the public.

2. The acquisition of the land and the building construction is financed largely with debt that provides for simple and compound interest, both of which are payable together with the principal on the maturity of the loan.

Our Comments

Written confirmation of the consequences inherent in particular transactions are given by this directorate only where the transactions are proposed and are the subject matter of an advance ruling request submitted in the manner set out in Information Circular 70-6R5. Where the particular transactions are partially completed or completed, the enquiry should be addressed to the relevant Tax Services Office. Notwithstanding the foregoing, we are providing the following comments.

Compound Interest and Subsections 18(2) and 10(1.1)

You have asked whether accrued but unpaid compound interest that relates to the purchase of vacant land that is inventory is to be added to the cost of the land.

A deduction for compound interest may be permitted pursuant to paragraph 20(1)(d) of the Act, but only when it has been paid. Subsection 18(2) of the Act is not an enabling section, but instead restricts the amount that may be deducted for certain outlays and expenses (including interest and compound interest) that would have otherwise been deductible. Therefore, until an amount that is compound interest has been paid, neither subsection 18(2) of the Act nor subsection 10(1.1) of the Act will have any application.

This position would also apply if the land were disposed of before the compound interest was paid. Although we expect that it would be unusual for a creditor to permit the relevant land to be disposed of before the compound interest was paid, if you anticipate that this will be a proposed transaction we would be pleased, in the context of an advance ruling request, to consider how the payment of compound interest would be classified for income tax purposes.

Compound Interest and Subsection 18(3.1)

You have asked whether accruing but unpaid compound interest that can reasonably be considered to relate to the period of construction of a building that is a condominium is to be added to the cost or capital cost of the building, or whether it is to be allocated between one or more of the "condominium units".

Compound interest may only be deducted pursuant to paragraph 20(1)(d) of the Act when it has been paid and may only be added to the cost or the capital cost of the building pursuant to paragraph 18(3.1)(b) of the Act when it has been paid.

Like subsection 18(2) of the Act, it is our view that paragraph 18(3.1)(a) of the Act is not an enabling section with respect to the deductibility of amounts. Instead, it precludes a deduction for certain outlays and expenses (including interest and compound interest) that would have been otherwise deductible. While paragraph 18(3.1)(b) of the Act permits the deduction which has been so denied by paragraph 18(3.1)(a) of the Act to be added to the cost or capital cost of the building, it will only do so once paragraph 18(3.1)(a) has already applied to the amount. [In our opinion, the amendment that added the words "to the extent that it would otherwise be deductible in computing the taxpayer's income for the year" that were added to paragraph 18(3.1)(b) of the Act merely provides greater certainty that "such an outlay or expense" [emphasis added] in paragraph 18(3.1)(b) of the Act refers to those amounts where paragraph 18(3.1)(a) of the Act applied to preclude a deduction.] Accordingly, paragraph 18(3.1)(b) of the Act will not apply in respect of compound interest until it has been paid (when paragraph 18(3.1(a) of the Act would have had application).

As described in paragraph 2 of Interpretation Bulletin IT-304R, Condominiums, our understanding of the legal basis of a condominium is as follows:

"2. A condominium combines two distinct types of property ownership. A unit owner normally owns the unit in fee simple and shares ownership of the common areas of the condominium property with all the other unit owners. A condominium is legally created by the acceptance and registration of a "declaration" and "description" or a "strata plan" in the appropriate land registry or land titles office. Generally, the legal consequences of such registration are as follows:

(a) A condominium corporation, as discussed in ¶ 3, comes into existence and its members become the owners of the "units" or "strata lots" so created as a result of the incorporation (collectively referred to as units in this bulletin).

(b) Units may be dealt with and regarded as real property and are held in fee simple by the owner. A unit is either the separate unit structure or that portion of a multi-unit structure which consists of all the space between the partitions, floors and ceilings separating it from other units and from the common elements or common property.

(c) Each such owner shares ownership of the "common elements" or "common property," which is all that part of the land and buildings not included within any units. Such common elements or property include parking lots, landscaped areas, laundry rooms, hallways, elevators, and stairwells. The proportional interest in the common elements or property is established in the documents filed in the land registry or land titles office."

Where subsection 18(3.1)(b) of the Act applies, an amount is added to the taxpayer's cost or capital cost of the building. Regardless of whether the taxpayer has sold one or more "condominium units " in the building, there would be no adjustment to the cost or capital cost of the taxpayer in the building until the compound interest was paid. (Our understanding is that although the "builder/taxpayer" may have sold one or more condominium units in its building, the builder/taxpayer's remaining interest in the building would be one legal property.)

As we stated above in connection with a disposition of land, we would also consider it unusual for a creditor to permit a disposition of a building before it has been paid the compound interest that had accrued. However, if such a situation is seriously contemplated, we would be willing to consider a request for an advance income tax ruling as to whether the amount may otherwise be deducted when paid.

The foregoing comments represent our general views with respect to the subject matter. As indicated in paragraph 22 of Information Circular 70-6R5, the above comments do not constitute an income tax ruling and accordingly are not binding on the Canada Customs and Revenue Agency. Our practice is to make this specific disclaimer in all instances in which we provide an opinion.

Yours truly,

Steve Tevlin
Manager
Corporate Financing Section
Financial Industries Division
Income Tax Rulings Directorate