23 April 2003 External T.I. 2002-0179085 - 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 borrowed money used for the purpose of earning income

Position TAKEN:

Position released at Canadian Tax Foundation in October 2002

XXXXXXXXXX 2002-017908
G. Moore
April 23, 2003

Dear XXXXXXXXXX:

Re: Paragraph 20(1)(c) of the Income Tax Act

This is in reply to your letter of November 25, 2002, addressed to the Burnaby-Fraser Tax Services Office, which was forwarded to us for reply.

In the first scenario ("Scenario 1"), an individual owns all of the issued and outstanding shares of a professional corporation. The professional corporation's only significant asset is an interest in a professional partnership. The corporation has a capital and income interest in the partnership. The partnership will distribute funds to the professional corporation as a repayment of the capital account. The professional corporation will make a shareholder loan to the individual who will use the funds to repay an existing mortgage on his home. The individual borrows money to repay his shareholder loan and you are asking if the interest on the money borrowed by the shareholder would be deductible by him under paragraph 20(1)(c) of the Income Tax Act (the "Act").

In the second scenario ("Scenario 2"), an individual borrows money and makes a shareholder loan to his professional corporation, which in turn lends the money to a professional partnership. The partnership would then make a distribution to the corporation which would then repay the shareholder. You are asking if the interest on the money borrowed by the individual and used to make a shareholder loan to his professional corporation would be deductible by the individual under paragraph 20(1)(c) of the Act.

Our Comments

It appears that the situation you describe concerns a completed or proposed transaction and therefore, we are unable to provide any confirmation of the tax consequences except, with respect to a proposed transaction, in the context of an advance income tax ruling. Confirmation of the tax consequences respecting a completed transaction must be obtained from the local tax services office. We can offer, however, the following general comments.

Scenario 1:

Subparagraph 20(1)(c)(i) of the Act allows a deduction for interest on borrowed money used for the purpose of earning income from a business or property. On October 1, 2002, we presented at the Canadian Tax Foundation an update on our preliminary review of our existing interpretative and administrative positions on interest deductibility. Paragraph 20(1)(c) of the Act restricts the circumstances where interest on borrowed money is deductible to cases where borrowed money is used to earn income from a business of the borrower or to acquire an income-producing property.

Borrowed money which is used to repay a loan would be deemed by subsection 20(3) of the Act to have been used for the same purpose for which the money previously borrowed was used. Since the purpose of the initial borrowing was to pay a home mortgage, which would be an ineligible use, interest on the borrowing to repay the shareholder loan would not be deductible under paragraph 20(1)(c) of the Act.

Scenario 2:

In paragraph O of the discussion paper, the sentence beginning with, "Funds borrowed by a shareholder which are used to contribute surplus to a corporation are not used for either of these purposes. Thus, interest on borrowed money for such purposes is not deductible." is generally meant to refer to contributed surplus or other forms of capital contributions by a shareholder. Since most shareholder loans involve an interest-free loan to a corporation, we direct you to paragraph M of the discussion paper.

M. Borrowing to make interest-free loans.

In such circumstances, the direct use of the borrowed money is ineligible since no income can be generated from the property acquired. Thus, interest on borrowed money to acquire such property is generally not deductible. However, in certain factual situations, a deduction may be available under the exceptional circumstances category. No comprehensive guidelines can be provided as to when such borrowing would qualify. However, we would generally accept the deduction of interest on borrowed money used to make an interest-free loan to a wholly-owned corporation (or in cases of multiple shareholders, where each shareholder makes an interest-free loan in proportion to their shareholdings) where the proceeds will be used by the corporation to produce income, thereby increasing the potential dividends to be received. Interest deductibility in other situations involving interest-free loans may also be warranted depending upon the particular facts of a given situation.

Accordingly, it is a question of fact whether an individual shareholder can establish an income earning purpose for a loan made to the shareholder's corporation which would result in an interest deduction to that particular individual.

On February 18, 2003, as part of the presentation of the Federal budget, the Department of Finance published the following statement concerning the deductibility of interest:

"Recent court decisions have raised uncertainties as to how taxpayers are to treat expenses, in particular interest, in computing income from a business or property for purposes of the Income Tax Act. Most notably, these decisions could lead to inappropriate tax results where a taxpayer derives a tax loss by deducting interest expenses, even if under any objective standard there is no reasonable expectation that the taxpayer would earn any income (as opposed to capital gains), or where the presence or the prospect of revenue (as opposed to income net of expenses) is enough to conclude that an expenditure was incurred "for the purpose of earning income".

Neither of these results is consistent with appropriate tax policy, nor would they have been generally expected under prior law and practice. Therefore legislative amendments to the Income Tax Act will be considered in order to provide continuity in this important area of the law. Before finalizing any proposals, however, the Department of Finance will release them for public consultation, with a general goal of ensuring that they restore continuity with the expected consequences before these recent court decisions."

We trust that these comments will be of assistance.

Yours truly,

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

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