15 August 1988 Income Tax Severed Letter 7-1881 - [880815]

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.

August 15, 1988

HEAD OFFICE Financial Industries Division M. Loveday (613) 957-8961 SUBJECT: XXXX

This is in reply to your memorandum of June 15, 1987 wherein you requested our views on the treatment of the interest expense incurred by XXXX with respect to his investments in the XXXX and the XXXX . We apologize for the delay in our reply. Unless otherwise indicated all references to statutes are to the Income Tax Act.

Based on a review of the Offering Memorandums. Partnership Agreements and the 1985 Financial Statements for the XXXX and XXXX our understanding of the relevant facts is as follows.

FACTS

XXXX

ANALYSIS

Subsection 18(3.1)

You are proposing to deny XXXX request to claim a deduction for the interest paid on the XXXX Loan and the XXXX Loan based upon subsection 18(3.1) and paragraph 18(3.2) XXXX.

Subsection 189(3.1), in conjuction with subsection 18(3.2) works to deny a deduction for interest paid by a taxpayer during a construction period in respect of borrowed money that can reasonably be considered to have been used to assist, directly or indirectly, a partnership with whom the taxpayer does not deal at arm's length, to construct a builing or to purchase land. In this case, subsection 18(3.2) would only be applicable where the funds derived from the XXXX can be traced, directly or indirectly, to the funds used to assist the partnerships in the construction of the XXXX (hereinafter referred to as the "Properties"), or in the acquisition of the Land.

However, even if we suceed in establishing that part of the funds derived from XXXX Loan or the XXXX Loan was indirectly used to assist the partnerships to construct the properties or to purchase the Land, it would be necessary to demonstrate that XXXX does not deal at arm's length with the partnerships. Since there does not seem to be any evidence of a non-arm's length relationship between XXXX and the partnership, we would not recommend persuing this approach.

Prepaid Rent

It was suggested that we apply subsection 18(9) to the interest on funds borrowed to prepay rent XXXX under the XXXX agreement. The interest appears to be payable each year; and therefore could not be considered "prepaid" interest. Additionally we do not feel that the interest could be considered to be "in lieu of" prepaid rent. However the lump sum prepayment itself should be examined.

From the information we have, this situation resembles the case of Her Majesty the Queen and Harold N. Moore (FCTD, 1986, CTC 22). The major difference is that the Moore lease involved a purchase option at the end of the 60 year lease. If further investigation shows that there is some type of purchase option that it is reasonable to assume will be excerised, you should probably assess on the basis of the Moore case. That is, the prepaid rent should be considered a leasehold interest. Accordingly we would allow the prepayment to be amortized evenly over 40 years, as described in schedule III of the Income Tax Regulations.

On the other hand, if the facts do not support assessing on the basis that this is a capital asset, then subsection 18(9) should apply to restrict the deduction of the prepaid amount to the amount that is in respect of the current year. We know of no reason to amortize a prepaid rent amonut on a declining basis. In fact the amortization should probably be on an increasing basis to account for inflation. However, in practice we accept a straight-line amortization over the term of the lease as a reasonable method of expensing the prepayment.

Interest Deductibility

In order for XXXX to claim a deduction for the interest paid on the XXXX loan and the XXXX Loan, he will have to show that the loan was used for the purpose of earning income from a business or property - in accordance with the provisions of subparagraph 20(1)(c)(i) of the Act. Subsection 9(3) of the Act provides that "income from a property" does not include any capital gain from the disposition of that property. Thus if the units were acquired with a view to long term capital appreciation, this would not be "for the purpose of earning income".

In the recent court case, HMQ v. Phyllis Barbara Bronfman Trust (1987 (1) CTC 117) the Supreme court did not actually rule on the 'earning income' issue. However, Chief Justice Dickson did have the following to say.

Indeed, it is of more than passing interest that the assets which were preserved for a brief period time yielded a return which grossly fell short of the interest costs on the borrowed money. In 1970, the interest costs on the $2.2 million of loans amounted to over $110,000 while the return from an average $2.2 million of trust assets (the amount of capital "preserved") was less than $10,000. The taxpayer cannnot point to any reasonable expectation that the income yield from the trust's investment portfolio as a whole, or indeed from any single asset, would exceed the interest payable on a like amount of debt. The fact that the loan may have prevented capital losses cannot assist the taxpayer in obtaining a deduction from income which is limited to use of borrowed money for the purpose of earning income.

Subsequent to the Bronfman decision, the Department of Finance issued a Release on June 2, 1987, indicating that they intend to amend the law retroactively. The amendment would make this interest deductible to the extent of income earned from the partnership.

Based on a review of the two Schedule B's and Schedule C's of the partnerships' Offering Memorandums and the schedules attached thereto, it would appear XXXX

we would take the partner's share of the income or loss of the partnership and deduct from this his personal carrying costs.)

XXXX

Existence of XXXXXXXX partnership might be assessed on the basis that there is no actual partnership since the "partnership" does not appear to be carrying on any business.

XXXX

The accepted definition of a partnership is "the relation which subsists between persons carrying on a business in common with a view of profit". (uniform partnership acts). The following statement, appearing in IT-434R , paragraph 8, supports the same principal:

Where two or more individuals participate in a rental operation, the question of whether it is a business still must be determined according to the principles outlined above. The fact that a rental operation is carried on by what appears, or purports, to be a partnership does not, in itself, justify an assumption that the operation therefore must be a business. Where, however, the application of those principles indicates that a rental operation is a business, the fact that the relationship of its owners appears, or is claimed, to be that of partners rather than merely co-owners tends to confirm the other indications that it is indeed a business.

A 1967 case before the Exchequer Court of Canada (MNR v M. Cada; R.N. Sequin v MNR; 1967 CTC 249) held that "... as their operations in relation to this property never, in fact, reached the stage of carrying on a business in common, there is no evidence upon which I can find ... that there was a relationship ... that would fall within the statutory definition of 'partnership'".

Considering these points we believe that there is reason to question whether partnership even exists under the XXXX agreement. One result of looking through the partnership is that no -- CCA would be allowed over the XXXX year period as the interest on the XXXX loan would create a loss before CCA. It seems that this approach could be handled by Avoidance or by the regular Audit Division.

Miscellaneous Items

During our review of the material we noticed a few discrepancies:

XXXX

We hope our comments will be of some assistance to you. Please let us know if you would like any further information.

Director

Financial Industries Division Rulings Directorate