21 August 1991 External T.I. 9018685 F - 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.

August 21, 1991

Dear Sirs:

Re: Interest Deductibility

This is in response to your letter dated August 7, 1990, in which you requested our views as to whether interest would be deductible in the hypothetical situation which you described.

Except where otherwise stated, all statutory references in this letter are to the Income Tax Act. [1]

Our views are based on the following assumed facts:

     1.   A corporation ("ACo") carries on the business of acquiring and then leasing commercial real estate properties to third parties.

     2.   ACo has borrowed money from institutional lenders, which was used by ACo to acquire certain of the properties that are used in its leasing business.  ACo's indebtedness to the institutional lenders has been secured by the granting of mortgages on the properties that were acquired with the borrowed money.

     3.   In computing its income from its business, ACo is entitled, pursuant to subparagraph 20(1)(c)(i), to deduct the interest that is payable on such borrowed money.

     4.   ACo has two shareholders, Xco and Yco, each owning 50% of the issued shares of ACo.

5.        A conventional butterfly reorganization will be undertaken, in conformity with paragraph 55(3)(b), to divide Aco's real estate between the two shareholders.  In the course of this reorganization, the properties will be transferred to the two shareholders pursuant to subsection 85(1).  Each shareholder will assume the mortgages relating to the properties which it is acquiring and will issue shares to ACo for the balance of the purchase price.

6.     XCo and YCo will assume the respective mortgages in such a manner that they will each have a legal obligation:

(a)       to pay to the institutional lenders the principal and interest secured by such mortgages; and

(b)       to indemnify ACo with respect to the assumed mortgages. [2]

The amount of the interest that will be paid or payable by XCo and YCo will be reasonable.

7.     Immediately before the above reorganization the cost amount (as defined in subsection 248(1)) to ACo of each property will be greater than or equal to the outstanding amount of the indebtedness which is secured by the mortgage against such property.

8.     After the above reorganization XCo and YCo will use their respective properties for the purpose of earning income therefrom or from a business.  No part of such income will be exempt (within the meaning contemplated by subsection 248(1)).

It is our understanding that your purpose in asking our views in respect of the above situation is to focus on the issue of whether the assumption of a debt will, in and by itself, preclude the deductibility thereafter of interest paid or payable in respect of the assumed debt.

It is our view that, in a typical vendor-purchaser transaction where the purchase price of real property encumbered by a mortgage includes the principal outstanding under the mortgage (i.e., the mortgage is assumed), the amount of such assumed mortgage is part of the amount payable by the purchaser.  In this regard, Di Castri states the following:

Prima facio, and in the absence of a stipulation to the contrary, a purchaser who accepts a conveyance of an estate subject to a mortgage is bound under an obligation of conscience to indemnify his vendor-grantor against the mortgage debt; the amount of such debt is in effect part of the purchase money. [3]

Since the assumed mortgage debt is part of the amount payable for the property, any interest payable under the mortgage will come within subparagraph 20(1)(c)(ii) (assuming that all the other requirements of the subparagraph are met).

Hence, in the above hypothetical situation, the assumption by XCo and YCo of the mortgages originally granted by Co will not, in and by itself, preclude the subsequent deductibility of the mortgage interest.  Accordingly, it is our view that, after the above reorganization, XCo and YCo will be entitled, pursuant to subparagraph 20(1)(c)(ii), to deduct, in computing their respective incomes for a taxation year, the interest that is paid in the year or is payable in respect of the year (depending upon the method regularly followed by them in computing their incomes) pursuant to the assumed mortgages.

The foregoing comments represent our general views in respect of the issue raised by your letter.  These views may require qualification when applied to a specific transaction.  As explained in paragraph 21 of Information Circular 70-6R2, the above comments are not advance rulings and are not binding on the Department.

Yours truly,

for DirectorReorganization and Non-Resident DivisionRulings DirectorateLegislative and Intergovernmental Affairs Branch