16 August 2007 External T.I. 2006-0209001E5 - Interest Deductibility - Returned principal

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.

Principal Issues: Individual borrows money from the bank to invest in preferred shares, which are redeemed with an interest-bearing note. The bank loan remains outstanding for its term of 24 months whereas the individual receives repayments of interest and principal on the note. The individual uses the repaid principal for personal use. First, can the individual continue to deduct interest on the bank loan under paragraph 20(1)(c) after the preferred shares are redeemed? Second, if so is the interest expense on the portion of the bank loan pertaining to the repayment of principal on the note still deductible under paragraph 20(1)(c)?

Position: To the extent that the current use of the bank loan is to earn income from the note, the interest on the bank loan is deductible. Accordingly, to the extent that the principal amount of the note is repaid, the principal amount of the outstanding bank loan is not being used to earn income.

Reasons: It is the current use of borrowed money that determines the deductibility of interest under paragraph 20(1)(c). Accordingly, with respect to the repayment of principal on the note, the current use of that portion of the bank loan 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 IT-533, 9511817, 9326621, 9726133, 2001-0081025, 2001 0110455,2002-0142475

XXXXXXXXXX 								2006-020900
M. Thomson
August 16, 2007

Dear XXXXXXXXXX:

Re: Interest deductibility

This is in reply to your email of October 4, 2006 wherein you requested our comments on whether the interest on the outstanding loan balance would remain deductible in the following example.

In 2003, an individual borrowed $100,000 from the bank to invest in preferred shares. The shares were redeemed in 2006 with an interest-bearing note repayable over two years. The entire loan will remain outstanding for the two-year period, until the note is fully repaid, and interest expense incurred thereon. The individual has claimed a deduction for interest expense on their personal tax return for the 2004 and 2005 taxation years. You are enquiring as to whether the interest on the loan will continue to be deductible for tax purposes subsequent to the redemption of the preferred shares. You also query whether the full amount of the interest paid on the loan for the year is deductible and if not whether you should apply the monthly principal payments received on the note against the bank loan for purposes of calculating the amount of interest deductible for the year.

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 matter of an advance ruling request submitted in the manner set out in Information Circular 70-6R5 entitled Advance Income Tax Rulings, dated May 17, 2002. Where the particular transactions are completed, the enquiry should be addressed to the relevant tax service office. The following comments are, therefore, of a general nature only and are not binding on the Canada Revenue Agency ("CRA"). Unless otherwise stated, all statutory references are to the Act.

Subparagraph 20(1)(c)(i) permits the deduction of an amount paid in the year or payable in respect of the year, pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from a business or property. In general, the test to be applied for the use of borrowed money is the direct use of the borrowed money and it must be done giving effect to the legal relationship. Furthermore, 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.

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, [1970] C.T.C. 537, 70 D.T.C. 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, [1987] 1 C.T.C. 117, 87 D.T.C. 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. Also, refer to Interpretation Bulletin IT-533, more specifically paragraphs 17 and 18, for further information.

Based on the above, the current use of the borrowings in your situation is an investment in an interest-bearing note, therefore the interest thereon will be deductible so long as a link can be established between the loan and its current use.

In the example you described, the note is repaid monthly over 24 months from the date of redemption of the preferred shares. Accordingly, in our view, the amount of interest deductible on the loan for the year should be calculated as if the monthly principal repayments on the note for the year have reduced the loan balance. This should accurately reflect our view that the interest on the portion of the loan that represents a repayment of principal on the note would not be deductible since the current use is personal and not for an income earning purpose.

We trust that the foregoing will be useful.

Yours truly,

R.A. Albert, CA
For Director
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate