2 May 1996 Internal T.I. 9612827 - INTEREST DEDUCTION FOLLOWING CHANGE IN SOURCE

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

Does interest on a loan remain deductible when the source changes ?

Position:

Yes

Reasons:

20.1, John Tennant 96 DTC 6191

			May 2, 1996

Vancouver Island Tax Services Headquarters
Audit Division C. Tremblay
(613) 957-2744
Attention: Bruce Donaldson
Assistant Director
961282

Deductibility of Interest

We are writing in response to your memorandum of April 10, 1996, wherein you requested our opinion regarding the interest deduction and the loss of source rules in the situation described therein.

The Facts as Given

XXXXXXXXXX

XXXXXXXXXX

TSO Position

The Vancouver Island Tax Services has not made an assessment with respect to the transactions but considers that the source of income may have ceased. In their view, this situation appears to fall within the criteria and intent of section 20.1 and subsection 20.1(5) of the Act. The TSO is worried that if the taxpayer is permitted this claim, he will likely have a perpetual interest deduction as no principal is paid on the loan.

Taxpayer's Position

The taxpayer's representative argues that the substitution of property does not result in a loss of an interest deduction. Pursuant to the series of transactions, the taxpayer now holds a number of shares in XXXXXXXXXX

Our Comments

Section 20.1 of the Act contains rules that apply where, because of a loss of source of income which occurs after 1993, borrowed money ceases to be used for an income-earning purpose. Consequently, this section will not apply where the loss of source of income occurred prior to 1994. This position is further clarified in the explanatory notes (page 19) which states that the new rules apply where the loss of source of income occurs after 1993. Since in the case at hand the income source would have changed or ceased before 1994, the rules found in section 20.1(1) have no application.

Prior to 1994, our view was that if money is borrowed to acquire a source of business or property income and the original source is disposed of and replaced with a new source, the interest on the original loan should be deductible, at least to the extent of the cost of the new source. At the 1984 Round Table of the Canadian Tax Foundation, we stated in answer to Question 18 that it is the Department's Position supported by several cases including Trans-Prarie Pipelines v MNR (70 DTC 6351) as well as the Alexander case (75 DTC 5412), that interest sought to be deducted under paragraph 20(1)(c) of the Act must relate to a business or property income source. This requirement will not be satisfied in circumstances where the income source ceases to exist, is transferred, or changes use (for example, where a rental property becomes the owner's personal residence). Where one income source is disposed of and the proceeds are used to acquire another income source, interest on the borrowed money that was used to acquire the first income source will continue to be deductible to the extent that the borrowing is reflected in the cost of the new income source.

However, in John Tennant v Her Majesty the Queen 96 DTC 6191, the taxpayer deducted interest expense on a loan where the value of the shares had decreased and then transferred to a new entity under section 85 of the Act. Since it is the current use rather than the original use which is relevant in determining the deductibility of interest payments, the taxpayer needed to establish a link between the new investment, the proceeds of disposition and the money borrowed to acquire the original shares. This the taxpayer was able to satisfy. His original investment which was the first source of income, was simply exchanged for his new investment. The court ruled that the basis for an interest deduction under paragraph 20(1)(c) of the Act is not the value of the replacement property but the amount of the original loan. Accordingly, the taxpayer was entitled to claim all of the interest which he had claimed in respect of the taxation years in issue.

In our view, the decision in John Tennant is directly on point with the case at hand. Accordingly, the taxpayer should be allowed to continue to deduct the interest on the original $XXXXXXXXXX loan.

for Director
Financial Industries Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch