9 September 2003 External T.I. 2003-0025345 - INTEREST EXPENSE

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 interest paid or payable on a mortgage following a change in use of a property from non-income producing to income producing will be deductible in computing income from this source?

Position TAKEN:

Provided the taxpayer establishes a link between the money that was borrowed and its current eligible use - Yes.

Reasons FOR POSITION TAKEN:

Where property purchased with the borrowed funds was not originally used to earn income and subsequently its use changed to become income producing, we would look to the use of the borrowed funds in the year that the interest expense is incurred in order to determine whether, for purposes of subparagraph 20(1)(c)(i) of the Act, the interest paid or payable is in respect of the year on "borrowed money used for the purpose of earning income".

XXXXXXXXXX 								2003-002534
P. Diguer, CGA
September 9, 2003 

Dear XXXXXXXXXX:

Re: Subparagraph 20(1)(c)(i) of the Income Tax Act (Canada) (the "Act")

We are writing in response to your facsimile dated June 19, 2003 in which you request an advance income tax ruling in regard to the deductibility of interest paid or payable on borrowed money following the change in use of a property.

In particular, you describe a situation where the occupants of a personal residence (the "Property"), which they acquired in part with borrowed money obtained from a financial institution on the security of a mortgage ("the Mortgage"), will be moving.

Upon moving, the occupants may convert the Property into a rental property (the "Conversion") in which case they will continue financing the Property with the borrowed money secured by the Mortgage. Alternatively, the Property will be sold.

You Ask:

If the Property is converted into an income producing rental property will the interest paid or payable on the Mortgage following the Conversion be deductible in computing income from this source for purposes of the Act?

Our Comments

As indicated in Information Circular IC-70-6R5 ("IC-70-6R5") dated May 17, 2002 (copy enclosed), an advance income tax ruling is a written statement given by the Income Tax Rulings Directorate to a taxpayer stating how the CCRA will interpret and apply specific provisions of existing Canadian income tax law to a definite transaction or transactions which the taxpayer is contemplating. The CCRA charges a fee for this service (currently $100.00 (plus GST) for each of the first 10 hours and $155 (plus GST) for each subsequent hour). As also indicated in IC-70-6R5, advance income tax ruling requests must include an advance payment equal to five hours of work plus GST ($535.00), copies of all relevant documents and contain the information set out in paragraph 16. Your request does not include any of the above-mentioned material. Should you wish to proceed with an advance income tax ruling request please submit a request that complies with the requirements set out in IC-70-6R5.

As further stated in paragraph 22 of IC-70-6R5, CCRA also provides, in writing, technical interpretations of specific provisions of the Act and accordingly, we offer the following general comments in connection with your request which we hope will be of assistance to you. However, as also stated in paragraph 22 of IC-70-6R5, written opinions are not advance tax rulings and, accordingly not binding on the Agency.

Principal Residence - Change in Use

Generally, a housing unit may be designated as a principal residence for each year that it is ordinarily inhabited by the taxpayer or by his or her spouse or child, during which he/she was resident or deemed to be a resident in Canada. Where a property qualifies as an individual's principal residence, the principal residence exemption may be used by that individual to reduce or eliminate any capital gain otherwise occurring either when the property is disposed or deemed to be disposed. Please see paragraph 8 of IT-120R6 (copy enclosed) for a detailed explanation of the calculation of the amount eligible for the exemption.

Where the owner of a principal residence ceases to live in the property and commences to use the building as an income producing asset, there would be a deemed disposition and immediate reacquisition of the property converted to the new use for proceeds and cost equal to the property's fair market value at the time of conversion. Any resulting gain on the deemed disposition is usually eliminated by the principal residence exemption (as suggested in the preceding paragraph).

Mortgage interest deductibility

Subparagraph 20(1)(c)(i) requires, inter alia, that interest sought to be deducted be on "borrowed money used for the purpose of earning income from a business or property".

Use of borrowed money

The Courts have considered the interpretation of the term "used" and in particular whether used means first used or currently used and we are informed by their findings in regards to this matter. In this regard, several decisions by the Supreme Court of Canada, notably, Canada Safeway Ltd v. MNR, (SCC) 57 DTC 1239, The Queen v. Bronfman Trust, (SCC) 1987 [1] CTC 117, 1987 DTC 5059 and Shell Canada Limited v. The Queen, 1999 [4] CTC 313, 1999 DTC 5669, have made it clear that the relevant use is the current use and not the original use of the borrowed money. In determining the current use of the borrowed money, taxpayers must establish a link between the money that was borrowed and its current use.

For example, where interest paid or payable is on borrowed funds to acquire a principal residence, the interest payments will generally not be deductible, as the property linked to the borrowed money is not "used for the purpose of earning income from a business or property".

Tracing/ linking borrowed money to its current use

In simple situations where one property is replaced with another, such linking is straightforward. In these situations, the current use of the borrowed money is entirely with respect to the replacement property since all the proceeds of disposition from the original property are reinvested in the replacement property.

In the situation where property purchased with the borrowed funds was not originally used to earn income and subsequently its use changed to become income producing, we would look to the use of the borrowed funds in the year that the interest expense is incurred in order to determine whether, for purposes of subparagraph 20(1)(c)(i) of the Act, the interest paid or payable is in respect of the year on "borrowed money used for the purpose of earning income". Where it is determined that the interest paid or payable is on borrowed funds which are all, following a change in use, directly linked to an income producing property, the interest payments will generally be deductible as the property linked to the borrowed money is "used for the purpose of earning income from a business or property".

Accordingly, the mortgage interest will become deductible when you commence to use the property to earn rental income.

We trust our comments will be of assistance to you.

Yours truly,

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