15 August 2012 External T.I. 2012-0446741E5 - 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: Whether the interest on funds borrowed from a financial institution by a shareholder and used to acquire preferred shares of a corporation is deductible by the shareholder when there is a subsequent return of capital from the corporation to that shareholder.

Position: No.

Reasons: The borrowed money is not used for the purpose of earning income from a business or property.

XXXXXXXXXX
2012-044674
Andrea Boyle, CGA
August 15, 2012

Dear XXXXXXXXXX:

Re: Interest Deductibility

I am writing in reply to your email received May 8, 2012 in which you have asked us to comment on whether interest on borrowing would be deductible under a hypothetical situation described as follows:

An individual is a shareholder of a corporation. The individual borrows money from a financial institution which the individual uses to acquire the equivalent value in preferred shares of the corporation with a dividend rate of x.xx%. The corporation subsequently makes a distribution of capital to the shareholder. The individual uses the returned capital funds for a variety of personal, non-income-producing purposes. The question is: Would the individual be entitled to deduct the interest on the borrowing to acquire the preferred shares for income tax purposes?

Written confirmation of the tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R5, Advance Income Tax Rulings, dated May 17, 2002. We are, however, prepared to offer the following general comments, which may be of assistance.

All statutory references in this letter are references to the provisions of the Income Tax Act, R.S.C. 1985 (5th supp.) c. 1, as amended (the “Act”).

Subparagraph 20(1)(c)(i) of the Act 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 is the direct use of the borrowed money. Specifically, 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, a taxpayer must establish a link between the money that was borrowed and its current use.
Paragraph 31 of Interpretation Bulletin IT-533 Interest Deductibility and Related Issues (which is available on the CRA website at http://www.cra-arc.gc.ca/E/pub/tp/it533/README.html) discusses borrowing for investments as follows:

¶ 31. Where an investment (e.g., interest-bearing instrument or preferred shares) carries a stated interest or dividend rate, the purpose of earning income test will be met "absent a sham or window dressing or similar vitiating circumstances" (Ludco)…

Therefore, under the legislation as it is currently enacted, interest on money borrowed to acquire preferred shares with a stated dividend rate will generally be deductible by an individual for income tax purposes.

As per paragraph 15 of IT-533: “A taxpayer may restructure borrowings and the ownership of assets to meet the direct use test.” In other words, it is generally acceptable for a taxpayer to undertake a series of bona fide transactions, the goal of which is replace personal borrowing (on which interest is not deductible) with borrowed money that is directly used for the purpose of earning income from a business or property (on which interest may be deductible).

Whether interest on borrowed funds to acquire preferred shares would continue to be deductible after a corporation returns capital to the taxpayer would depend upon whether the borrowed funds continue to be traceable to an eligible use. This determination would be a question of fact which would depend upon on all the facts and circumstances surrounding the return of the capital.

However, in the given situation, it is our view that the income-earning purpose of the borrowed money would no longer be met; as the capital is immediately returned to the shareholder, the borrowed money is not used in the corporation’s business. Interest on the loan would therefore not be deductible since the “current use” of the borrowed funds is personal rather income-earning.

We trust that these comments will be of assistance.

Yours truly,

Doug Watson
for Director
Corporate Financing Section
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch