16 October 1997 Internal T.I. 9724987 - EXEMPT INCOME

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:

1.If a corporation is an "exempt" corporation (per 149(1)(d)), does it earn "exempt income" as that term is used in subsection 21(1) and 21(3) ??

2.If an election under 21(1) or (3) is made, is it necessary that there be a direct relationship between the assets acquired and the borrowed money or is it sufficient that there be increases in outstanding indebtedness when assets were acquired.

Position:

1. No.

2.Must be a direct relationship

Reasons:

1.Refer to 149(10)(d) which contemplates an "exempt" corporation incurring a non-capital loss in a year in which it was exempt. Consequently, if it can have a non-capital loss, it must also be capable of earning income which is not "exempt".

2.Borrowed funds must be "used" to acquire assets - cf. Bronfman Trust and Attaie.

			October 16, 1997

	HALIFAX TAX SERVICES OFFICE			HEADQUARTERS
J. P. Dunn
	Attention : Steve Rundle				(613) 957-2747
	            Large Case Files
			972498

XXXXXXXXXX
Subsections 21(1)and (3) of the Act and "Exempt Income"

We are writing in response to your memorandum of September 17, 1997 regarding the above referenced corporation and, more particularly, whether that corporation is able to make an election pursuant to subsection 21(3) of the Act in respect of interest expense incurred in the course of the acquisition of depreciable properties at a time when the corporation was exempt from Part I tax by virtue of paragraph 149(1)(d) of the Act.

As you note, subsection 21(3) of the Act allows a taxpayer to elect to capitalize such interest that would, but for the election under that provision, have been deductible in computing the taxpayer's income, other than exempt income. Your specific concern is whether the income earned by the corporation when it was exempt from Part I tax would constitute "exempt income" as contempated in subsection 21(3) of the Act such that the corporation would be denied the ability to elect pursuant to the provision.

The reference in subsection 21(3) of the Act to "exempt income" parallels the exclusionary phrase in subparagraph 20(1)(c)(i) which denies the deduction of interest on borrowed money "used to acquire property the income from which would be exempt". Accordingly, if a deduction of interest is denied pursuant subparagraph 20(1)(c)(i) of the Act, the similar reference to income other than "exempt income" in subsection 21(3) prevents a taxpayer from deducting such interest as a claim for capital cost allowance in lieu of the denied direct deduction.

With respect to your query, we note that subsection 149(10) of the Act which deals with situations in which a corporation either becomes or ceases to be exempt from Part I tax, considers that, in either case, a corporation may have incurred a non-capital loss in a period prior to the change in its status. For example, in a circumstance in which an "exempt" corporation becomes "non-exempt", paragraph 149(10)(d) of the Act allows any non-capital losses incurred while it was an "exempt" corporation to be applied to income earned in years in which it is "non-exempt" but only to the extent that those losses could not otherwise have been utilised by the "exempt" corporation to reduce its taxable income in taxation years prior to becoming "non-exempt". Accordingly, if an "exempt" corporation can have taxable income in a taxation year (as is inferred in paragraph 149(1)(d)), it must also, therefore, have had income in that year which was not "exempt income".

We would not, therefore, consider that income earned at a time when a corporation is exempt from Part I tax constitutes "exempt income" as contemplated in subsection 21(3) or subparagraph 20(1)(c)(i) of the Act and would agree with your conclusion that the corporation is entitled to file the elections required by section 21 of the Act.

With respect to the quantum of interest to be capitalized, you have noted that, although it is not difficult to ascertain that there was, in fact, borrowed money which was used to earn income from a business, it may be difficult to isolate those amounts which were specifically used to acquire depreciable property as required by subsection 21(1) of the Act.

In our view, it would be necessary that the taxpayer be required to demonstrate that borrowed funds were used specifically to acquire depreciable property rather than simply asserting that, during a period in which there was an increase in borrowings, there were also purchases of depreciable property. This is not dissimilar to the circumstances in Her Majesty the Queen v. Said Mohammad Attaie 90 DTC 6413 (F.C.T.D.) in which the taxpayer had purchased investments with personal cash on hand and subsequently purchased a personal residence, part of the purchase price for which was financed with a mortgage. The taxpayer sought to deduct the interest on the mortgage as an expense against his investment income. The taxpayer's claim was rejected by the Court. The question in the Attaie case was whether the interest sought to be deducted was in respect of funds borrowed to produce income from a business or property. The decision was, basically, that it is not sufficient that there be borrowed funds outstanding at a time when there investment income being generated, but rather, that the borrowed funds must have been used directly to generate the investment income. As this was not the case, the taxpayer's claim for the interest deduction was rejected by the Court.

Although the facts in the present case are not identical to those in Attaie, it is our view that the principle of direct use of funds is equally applicable when considering the application of subsection 21(1) of the Act. The provision of the Act considered in Attaie was paragraph 20(1)(c) which requires, inter alia, that the borrowed money be "used for the purpose of earning income from a business or property". Similarly, subsection 21(1) of the Act allows a taxpayer to elect in respect of "borrowed money used to acquire... depreciable property". In the Attaie case, the Court quoted extensively from The Queen v. Bronfman Trust 87 DTC 5059 (S.C.C.) which required that there be tracing of the borrowed funds to the income earned. In our view, such a principle can be equally applied to the election pursuant to subsection 21(1) of the Act to require a tracing of the borrowed funds to the acquisition of depreciable property.

We trust that this is the information which you require.

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