5 June 2008 External T.I. 2007-0252211E5 - 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 trust units continue to be deductible when all distributions of income are reinvested in the same mutual fund trust, the unit holder subsequently sells exactly the same number of mutual fund trust units that were purchased through the reinvestment and uses the proceeds to pay part or all of the interest on the loan for the year.

Position: Only partially. Future interest on the borrowed money applicable to the prorated portion of original units disposed of will not continue to be deductible.

Reasons: Requirements of paragraph 20(1)(c) have not been met.

XXXXXXXXXX 							2007-025221
L. Carruthers, CA
June 5, 2008

Dear XXXXXXXXXX :

Re: Interest Deductibility - Current vs. Original Use

This is in reply to your correspondence dated September 12, 2007, and is a follow-up to our previous response to your questions regarding Scenario 2 of document 2007-023043. For ease of reference, we are reiterating the hypothetical Scenario 2 contained in our previous response and our previous comments:

Unit holder chooses to have all distributions of income reinvested in the same mutual fund trust and subsequently sells exactly the same of number of mutual fund trust units as were purchased through the reinvestment.

The source of income acquired with a portion of the original debt has been disposed of, and, as a result, interest on the borrowed money that was used to acquire that income source will continue to be deductible only to the extent that the borrowing is reflected in the cost of a new income source.

Given the fungible nature of mutual fund trust units, specific identification methods, such as LIFO and FIFO, are generally not applicable. In our view, the proportional method (shown below) is the appropriate method of identifying what portion of the originally purchased mutual fund trust units have been disposed of in the scenario you presented.

Given the facts:

Original cost of borrowing $ 100,000
Original units purchased (say) 80,000
Income re-invested $ 3,000
Units acquired on re-investment (say) 2,400
Units subsequently disposed of 2,400

Under the proportional method, the 2,400 units subsequently disposed of would be allocated between those units purchased originally and those purchased with re-invested income as follows:
80,000 x 2,400 = 2,330 units purchased originally
82,400

2,400 x 2,400 = 70 units purchased with re-invested income
82,400

Given the above, only 97.09% ((80,000 - 2,330) / 80,000) of the source of income acquired with the original debt remains, whereas 2.91% has been disposed of. Whether or not interest on the entire $100,000 original cost of borrowing remains deductible depends on the current use of the proceeds from the 2,330 original units disposed of (the "Proceeds").

In this situation, where the Proceeds are used:

• to pay down the original borrowing, interest on the remaining borrowing would continue to be 100% deductible;
• to acquire another source of income, interest on 97.09% of the original borrowing would continue to be deductible and interest on 2.91% of the original borrowing, to the extent it is reflected in the cost of the new income source, would be deductible; or
• for personal purposes, only interest on 97.09% of the original borrowing would continue to be deductible.

You now ask, given exactly the same hypothetical facts as outlined above, will all the interest payable for the loan continue to be deductible if the Proceeds of disposing of the 2,400 units are used to pay part or all of the interest on the loan for the year, but none of the principal.

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 IC 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.

As noted in our previous response contained in 2007-023043, in your situation, 2.91% of the source of income acquired with the borrowed money has been disposed of. As a result, to determine the continued deductibility of the interest on the borrowed money that was used to acquire that 2.91% of the source of income, the current use of the Proceeds would need to be determined, with the other requisite interest deductibility tests being applied to such use.

In your particular situation, the Proceeds from the units disposed of have not been used to acquire a new source of income nor have they been used to earn income from an existing source of income, rather, they have been used for the purpose of paying interest, which, in our view, is a capital expenditure and not a current operating expense incurred for the purpose of earning income from a business or property.

Therefore, in your particular situation, in our view, interest on 2.91% of the borrowed money would not continue to be deductible because the Proceeds from the units disposed of are no longer being used for the purpose of earning income from a business or property.

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