21 August 2007 External T.I. 2007-0236351E5 - 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.

Principal Issues: Will interest on money borrowed to invest in mutual fund units continue to be deductible following a return of capital?

Position: Depends on the current use of the capital returned.

Reasons: Current use vs. original use as noted in IT-533 paragraph 17.

XXXXXXXXXX 								2007-023635
L. Carruthers, CA
August 21, 2007

Dear XXXXXXXXXX:

Re: Interest Deductibility - Current vs. Original Use

This is in reply to your letter of April 26, 2007, wherein you asked our assistance to clarify the interest deduction that would be allowed pursuant to the Income Tax Act (the "Act") on an investment loan. This loan, on which interest only is being paid, is utilized to acquire mutual fund units for which, depending on returns, part of the monthly distributions could be a return of capital ("ROC"). Specifically, you question whether the deductibility of interest on the investment loan is dependent on the ROC given that the loan was obtained to purchase investments that would generate income other than only capital gains.

Our Comments

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 of an advance income tax ruling request submitted in a manner set out in Information Circular 70-6R5. As stated in paragraph 22 of Information Circular 70-6R5, written opinions are not advance tax rulings and, accordingly, are not binding on the Canada Revenue Agency (the "CRA"). The following comments are, therefore, of a general nature only.

Interest on borrowed money is deductible for purposes of the Act if it meets all the requirements of paragraph 20(1)(c) of the Act. Paragraph 20(1)(c) of the Act provides notably that the money must have been borrowed for the purpose of gaining or producing income from a business or property. It is the current use made of the borrowed money in a particular year rather than the original use of the money, which must be considered in determining whether the interest paid or payable with respect to the borrowed money is deductible in the particular year. Therefore, in order to determine whether borrowed money has been put to an eligible use in a particular year, it is necessary to determine the current use of the original borrowed money.

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, 70 DTC 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, you may 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, 87 DTC 5059, confirmed that it is the current use made of the borrowed funds in a particular year, rather than the original 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.

Where there is a ROC to the unit holder of a mutual fund (without any disposition of any portion of the property), it would be appropriate to consider that the income-earning purpose of the original borrowed money may no longer be met with regard to such returned capital. Therefore, when distributions from a mutual fund involve a ROC to the unit holder, the current use of the borrowed money with regard to such returned capital would need to be determined, with the other requisite interest deductibility tests applied to such use.

In this example, if we assume that the ROC by the mutual fund to the investor is not used for an income-earning purpose but is used for personal use, in our view, the interest on that portion of the borrowed money that relates to the return of capital from the mutual fund would not be deductible since its current use is personal and not for an income-earning purpose.

In the hypothetical situation you described, it is not clear when during the investment holding period the capital was returned to the investor. If we assume, for the purposes of this example, that the capital was not returned to the investor until the end of the first year, the current use of the borrowed money would be considered to be for income earning purposes for the entire duration of the first year and the related interest would generally be deductible provided all of the requirements of paragraph 20(1)(c) of the Act are met. For the second and following years of the investment, in our view, the interest on that portion of the borrowed money that relates to the return of capital from the mutual fund would not be deductible if its current use is personal and not for an income earning purpose.

We trust that our comments will be of assistance.

Yours truly,

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

cc Mr. Bill Bloss

Calgary Airport Taxpayer Services