13 February 2003 External T.I. 2003-0181585 - INTEREST DEDUCTIBILITY COMMON SHARES

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 to acquire common shares

Position TAKEN: Position released at Canadian Tax Foundation in October 2002

Reasons FOR POSITION TAKEN: N/A

XXXXXXXXXX 		2003-018158
G. Moore
February 13, 2003

Dear XXXXXXXXXX:

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

This is in reply to your e-mail of November 28, 2003, and further to the telephone conversation (Moore/XXXXXXXXXX) of January 24, 2003. In particular, you have asked the following questions concerning interest deductibility on money borrowed to acquire common shares.

1. If money is borrowed to acquire equity/growth mutual funds, is the interest on the borrowed money deductible if there is no guarantee that the mutual funds will pay dividends?

2. If stocks are acquired using a loan (borrowed money), is it necessary to hold them until the loan is fully repaid or is it possible to sell those stocks and replace them with other stocks during the period the loan is outstanding?

3. If borrowed money is used to acquire stocks, and dividends are paid on those stocks, for interest to be deductible on the borrowed money, is it necessary for the dividend to be reinvested in acquiring more stocks or can it be used for a non-income earning purpose? If borrowed money is used to acquire stocks, and those stocks have appreciated in value such that there would be a gain upon disposition of those shares, for interest to be deductible on the borrowed money, is it necessary for the gain to be reinvested in acquiring more stocks or can it be used for a non-income earning purpose?

4. If there is no mortgage on a principal residence, instead of taking a personal loan to invest in income-earning investments such as stocks, can an individual use the principal residence as collateral and use the proceeds from the mortgage on the principal residence to acquire stocks?

5. If stocks which were acquired with a principal residence mortgage loan are sold to repay the mortgage loan, is there a minimum period of time before the individual can take a new mortgage on the principal residence to invest in income-earning investments, such as stocks, in order for the interest to be deductible? For purposes of interest deductibility, is there a waiting period before stocks acquired using borrowed money can be sold?

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.

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. As you know, 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. One of these positions related to the deductibility of interest with respect to money borrowed to purchase common shares. The primary issue is the income earning purpose of the share acquisition. The purpose test is 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 borrowed 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.

With respect to interest on money borrowed to acquire income-yielding investments (ex. preferred shares or guaranteed investment certificates), this issue relates to the purpose test in paragraph 20(1)(c) of the Act regarding the acquisition of a debt or equity investment that has a stated interest or dividend rate. In Ludco, the Supreme Court has indicated that the purpose test 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).

2. If stocks are acquired using a loan (borrowed money) and assuming that the interest on the borrowed money to acquire the stocks is deductible, generally, the interest on the borrowed money would continue to be deductible if the individual sold the stocks and replaced them with other income-earning investments during the period the loan is outstanding. It is the current use of the borrowed money that is relevant.

3. Interest would continue to be deductible on the borrowed money used to acquire capital stock so long as the current use of the borrowed money is for income-earning purposes.

4. The collateral used to acquire borrowed money is not a relevant factor in determining whether interest on borrowed money is deductible under paragraph 20(1)(c) of the Act.

5. There is no minimum period of time before the individual can take a new mortgage on the principal residence to invest in income-earning investments, such as stocks, in order for the interest to be deductible. For purposes of interest deductibility, there is no waiting period before stocks acquired using borrowed money can be sold; however, interest on borrowed money would no longer be deductible after the income-earning investments are sold unless the borrowed money continues to be used for an income-earning purpose.

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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