13 August 2012 External T.I. 2012-0443481E5 - 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: Could the taxpayers deduct interest on new borrowed money used to “return capital to” or “repay loans from” themselves.

Position: No

Reasons: The taxpayers could not “return capital to” or “repay loans from” themselves.

XXXXXXXXXX						2012-044348
	L.M.  Carruthers, CA
August 13, 2012

Dear XXXXXXXXXX,

Re: Interest Deductibility

This is in reply to your e-mail of April 9, 2012, and further to our telephone conversation on May 9, 2012, (Lori Carruthers/XXXXXXXXXX) in which you described the following scenario:

• A corporation (the “Corp”) was formed a few years ago to own, as a bare trustee, a rental property situated in Ontario (the “Property”). All shareholders of the Corp are Ontario companies (the “ON Corps”) for income tax purposes.
• The Property was purchased with a combination of a mortgage from a financial institution (the “Mortgage”) and funds provided by the ON-Corps. The Corp is the registered owner of the Property.
• The ON-Corps have been reporting, for income tax purposes, the rental income and expenses (including the interest on the Mortgage) generated from the Property.
• Currently, the total balance of the funds provided by the ON-Corps on the purchase of the Property is approximately $1,000,000.
• The fair market value of the Property has increased, and an additional $300,000 will be borrowed from a bank (the “New Bank Loan”).

You indicated that the New Bank Loan would be used to “return capital to” or “repay loans from” the ON-Corps, and you asked for our assistance in clarifying whether the interest on the New Bank Loan would be deductible by the ON-Corps for tax purposes.

Our Comments

Your request appears to be an actual fact situation relating to a proposed if not a completed transaction. Written confirmation of the tax implications inherent in a proposed transaction is given by this Directorate only where the transactions are the subject of an advance income tax ruling request submitted in a manner set out in Information Circular 70-6R5. (This Information Circular and the Interpretation Bulletins referred to below can be accessed on the internet at http://www.cra-arc.gc.ca.) This Directorate does not give verbal or written confirmation of the tax implications inherent in a completed transaction. Such requests should be submitted, with all relevant facts and documentation, to your tax services office for their views.

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 and nothing in this letter should be construed as implying that the CRA has agreed to, reviewed or made any determination in respect of whether the Corp is holding legal title to the Property as a bare trustee or whether the ON-Corps are entitled to an interest deduction pursuant to paragraph 20(1)(c) for the interest on the Mortgage.

Paragraph 20(1)(c) of the Income Tax Act (the “Act”) allows a taxpayer to deduct simple interest paid or payable in the year on borrowed money used by the taxpayer for the purpose of earning income from a business or property. In the scenario described above, it would appear that the ON-Corps are currently deducting the interest on the Mortgage because it is their view that they used the proceeds from the Mortgage, as well as $1,000,000 of other funds, to acquire the Property from which they are earning income.

Subsection 20(3) of the Act provides, in general terms, that where a taxpayer uses borrowed money to repay money previously borrowed, the new borrowed money is considered to be used for the purpose for which the original borrowed money was used. So, in the scenario described above and to the extent the interest on the Mortgage is currently deductible by the ON-Corps, if the New Bank Loan were to be used by the ON-Corps to repay a portion of the Mortgage, as long as the Property continued to be held by the ON-Corps for the purpose of earning income from a business or property, pursuant to subsection 20(3) of the Act, interest on the New Bank Loan used to repay a portion of the Mortgage would be deductible.

If the New Bank Loan were to be used by the ON-Corps for a purpose other than repaying a portion of the Mortgage, the interest on the New Bank Loan would be deductible only to the extent that its use by the ON-Corps met the requirements of paragraph 20(1)(c). We refer you to Interpretation Bulletin IT-533, entitled Interest Deductibility and Related Issues, which discusses the CRA's interpretations of the deductibility of interest under various provisions of the Act and the judgments in numerous court decisions involving the deductibility of interest expense.

The courts (as commented on in IT-533) have determined that it is the direct use to which the borrowed money is applied which governs whether the interest is deductible for tax purposes. In our view, the direct use by the ON-Corps of the New Bank Loan could not be to “return capital to” or “repay loans from” the ON-Corps because they could not “return capital to” or “repay loans from” themselves.

We trust our comments will be of assistance to you.

Yours truly,

Doug Watson
For Director
Financial Industries Division
Income Tax Rulings Directorate