7 September 2007 External T.I. 2007-0221071E5 - Interest Deduction - Linking/Tracing

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: What amount of interest is deductible where a personal line of credit is increased, the additional borrowed money is used for investment purposes and then payments are made against the mortgage.

Position: A constant prorated portion based on initial eligible vs. ineligible use.

Reasons: Tracing/Linking concept relevant where cash and borrowed funds are co-mingled not where a single borrowed account is utilized for eligible purposes.

XXXXXXXXXX 							2007-022107
L. Carruthers, CA
September 7, 2007

Dear XXXXXXXXXX:

Re: Interest Deductibility - Tracing/Linking Through Lines of Credit

This is further to our September 20, 2006, reply to your request of July 21, 2006 (our reference # 2006-019886), wherein you asked for our assistance to clarify the interest deduction that would be allowed on an investment/personal line of credit based on the example that follows:

A taxpayer has a personal line of credit for $60,000 as of January 1, 20XX. In the same month, the personal line of credit is increased by $40,000 to a new balance of $100,000. The additional $40,000 was invested in securities for an income earning purpose with a financial advisor. You had concluded that for January the interest that can be deducted for income tax purposes is 40% of the interest paid or payable (depending on the method regularly followed by the taxpayer in computing the taxpayer's income) based on the $100,000 balance owing. The taxpayer then reduces the personal line of credit by paying down the balance by $20,000 as of February 1, 20XX. The new balance at February 1, 20XX is now $80,000 and the $40,000 remains invested with the financial advisor. Therefore, you had concluded that the interest that could be deducted for income tax purposes for February would be 50% of the interest paid or payable (depending on the method regularly followed by the taxpayer in computing the taxpayer's income) based on the $80,000 balance owing. The taxpayer then further reduces the personal line of credit by paying down the balance by $40,000 and the same amount remains invested with the financial advisor. You had concluded that for the balance of the year, the taxpayer is allowed to deduct 100% of the interest paid or payable (depending on the method regularly followed by the taxpayer in computing the taxpayer's income) on the line of credit.

In our response, we had referred to the flexible approach to tracing/linking as discussed in paragraph 20 of Interpretation Bulletin IT-533, entitled "Interest Deductibility and Related Issues", and had stated that the approach suggested in your example could be used, provided that the $40,000 of the personal line of credit continued to be used for the purpose of earning income from a business or from property.

We have revisited the approach suggested in your example and have concluded that it is not in line with the courts or Canada Revenue Agency's views on the flexible approach to tracing/linking. The approach suggested in your example would allow taxpayers to allocate repayments to specific advances from a line of credit and this was not the finding in Colin C. Mills v. MNR 85 DTC 632 ("Mills"), nor is it the intent of the comments in paragraph 20 of IT-533.

In Mills, at one time the taxpayer kept his investment and personal loan accounts separate. Through inadvertence, the accounts were merged. Following the merging of accounts, the Tax Court concluded that capital repayments could not be traced to the personal loan account vs. the investment loan account. The result of this was that, of the balance still to be paid, part was for investment and part was for personal use items. A portion of the interest claimed by the taxpayer was found to be not deductible.

Furthermore, the comments in paragraph 20 of IT-533 relate to tracing borrowed money, which is co-mingled in an account with cash, to eligible uses, and not to tracing or allocating repayments of money borrowed for various uses under a single line of credit to specific ineligible or eligible uses. In our view, any repayment of the principal portion of a line of credit would reduce both the portions of the line of credit used for eligible purposes and used for ineligible purposes.

Accordingly, in your example, the taxpayer cannot make payments on the personal line of credit that are specifically allocated to money that was borrowed for personal or ineligible uses. Once the line of credit is brought up to $100,000, its use is 60% ineligible and 40% eligible. Any payments on the line of credit will be considered made in that same ratio and any interest paid or payable (depending on the method regularly followed by the taxpayer in computing the taxpayer's income) will be deductible in that ratio. Therefore, when payments are made and the balance is reduced to $80,000, and then $40,000, the interest remains deductible on the basis of 60% ineligible and 40% eligible.

In your example, and as described in paragraph 15 of IT-533, it would be acceptable for the taxpayer to dispose of the investment and pay off the $40,000 March 1, 20XX, balance in the line of credit, and then reacquire the investment with a $40,000 line of credit (or other borrowing), for which the interest would be 100% deductible. Such a disposition would need to be reported for tax purposes. However, it should be noted that if a loss arises on the disposition and within 30 days the same investment is reacquired, rules regarding the claiming of superficial losses would apply. Generally, these rules operate to defer the recognition of losses for income tax purpose. Paragraph 11 of IT-456R, entitled "Capital Property - Some Adjustments to Cost Base", provides further comments on these rule.

We trust that these comments will be of assistance to you. The Interpretation Bulletins referred to in this letter can be found on CRA's website at: www.cra-arc.gc.ca.

Yours truly,

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