5 May 1998 Internal T.I. 9808496 - CAPITALIZATION OF INTEREST (COST PER PUPIL)

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 ISSUE:

(i) Whether a registered charity operating a school in a dual capacity (providing both secular (academic) and religious education) can, when determining the donation portion of an amount received by it as computed following either the two methods set out in paragraphs 7, 8 and 9 of Information Circular IC-75-23 (the “Exception”), elect under section 21(1) of the Income Tax Act (Canada) (the “Act”) to capitalize interest paid on a mortgage.

(ii) Whether interest paid on a mortgage by the registered charity would be considered a capital expenditure?

Position TAKEN:

(i) The issue is whether, in calculating the “cost per pupil” amount, the operating costs should include the interest paid on a mortgage. In our view, the computation should include the interest paid on the mortgage.

(ii) No.

Reasons FOR POSITION TAKEN:

(i) The calculation of the “cost per pupil” as described in paragraphs 7, 8 and 9 of IC-75-23 is merely an administrative concession by the Department in the specific circumstances set out in Information Circular 75-23. As such, the Department is free (within reason) to define the elements that are to be included in computing the amount it considers eligible for this administrative concession. Accordingly, the computation should be effected using the guidelines set out in IC-75-23 and the Information Letter without reference to any provision in the Act. The Information Letter requires the inclusion of the mortgage interest in the computation of the schools’ operating costs under both methods and any school that wishes to issue receipts under the Exception must compute the amount accordingly.

ii) In the present context the charity does not have “exempt income” within the meaning of subsection 21(1) or that the borrowed money was used to acquire property the income from which would be exempt within the meaning of paragraph 20(1)(c). As such, the charity would compute its’ income in accordance with the Act and in computing its’ tax payable, would look to subsection 149(1) for relief. Consequently, the charity could elect to have the provisions of subsection 21(1) apply where it would otherwise qualify.

				May 5, 1998

	HEADQUARTERS	HEADQUARTERS
	Charities Division	Income Tax Ruling and
				  Interpretations Directorate
	Attention:  Rhéal Dorval	P. Diguer
(613) 957-8953

	 			7-980849

Capitalization of interest

We are writing in response to your memo dated March 30 1998 in which you request our view as to whether a registered charity operating a school in a dual capacity (providing both secular (academic) and religious education) can, when determining the donation portion of an amount received by it as computed following either one of the two methods set out in paragraphs 7, 8 and 9 of Information Circular IC-75-23 , elect under subsection 21(1) of the Income Tax Act (Canada) (the “Act”) to capitalize interest paid on a mortgage.

Facts

Briefly, in the course of a routine audit of XXXXXXXXXX , each of which is a registered charity (the “Charities”), it was determined that, contrary to the guidelines set out in Information Circular IC-75-23, the Charities excluded the interest on the mortgage from the total operating costs in calculating the “cost per pupil” amount. The Charities consider that interest is by definition a capital expenditure and it is only by virtue of paragraph 20(1)(c) of the Act that interest is deductible as a current expense. As, in their view, they earn exempt income, paragraph 20(1)(c) would not apply, such that interest payments would constitute capital expenditures and would therefore be excluded from the computation total operating costs for purposes of calculating the “cost per pupil” amount.

The Charities Division is of the view that section 81 of the Act enumerates exempt income and does not include income from a registered charity and accordingly indicated that in order for the mortgage interest to be excluded from the total operating costs for purposes of calculating the “cost per pupil” amount, the Charities would be required to make an election to capitalize the interest payments on the mortgages under subsection 21(1) of the Act.

The Charities disagree with the Charities Division’s view. Rather, in the Charities view, they are not carrying on a business for the purpose of gaining or producing income and therefore, the capital assets acquired by the Charities would not constitute “depreciable property” for purposes of the Act such that the election under subsection 21(1) would not be relevant for the Charities.

Questions

Does the election under subsection 21(1) apply to charities? If our reply to the first question is negative, would the interest on the mortgage be considered a capital expenditure?

Our reply

The issue relating to the election under subsection 21(1) is not, in our view, the real issue in the present case. Rather, the real issue is whether, in calculating the “cost per pupil” amount, the operating costs should include the interest paid on a mortgage.

Administrative concession

It is well established in jurisprudence that, in order for a payment to qualify as a gift, the payor must, inter alia, not receive any consideration or advantage of a material character in return for the payment, and that training or education provided to children of a payor is consideration, regardless of the fact that there was no legal obligation to make the payment (see, for example, The Queen v. McBurney, 85 DTC 5433 (FCA), The Queen v John Zandstra, 74 DTC 6416 (FCTD), and The Queen v. Dr. F. Bruce Burns, 88 DTC 6101 (FCTD, affirmed 90 DTC 6335 FCA). However, in Information Circular 75-23 the Department sets out an administrative exception (the “Exception”) to the established common law rule under certain specific circumstances such that part of the payments made to an educational institution to allow children of the payor to attend the institution may qualify as charitable gifts (the “Gift”) where the institution is a registered charity and provides both secular and religious education.

The Exception is not law but merely an administrative concession by the Department in the specific circumstances set out in Information Circular 75-23. As such, the Department is free (within reason) to define the elements that are to be included in computing the amount it considers eligible for this administrative concession. The two methods (segregated net operating cost method and full net operating cost method) (the “Methods”) for calculating the Gift amount eligible for the Exception, described in paragraphs 7, 8 and 9 of IC-75-23, provide a fair means for determining a reasonable Gift amount for purposes of this administrative concession.

As the creator of the Exception and the author of the requisite guidelines for its application, it follows that the Department should provide guidance as to what constitutes an “operating cost” for purposes of IC-75-23. The Department does in fact provide such guidance and in this regard we look to the Information Letter (undated) (the “Letter”) issued by the Charities Division (copy provided with your memorandum). The last paragraph on page 2 of the Letter indicates that the operating costs include mortgage interest. Moreover, paragraph 3 of page 3 of the Letter indicates that the principal on loans is not considered a current operating cost and should not be included in the “cost per pupil” calculation.

In short, the Exception is a very generous concession and is an exception to the common law definition of a gift. The Department has set out strict guidelines that not only restrict this concession to situations that are targeted by IC-75-23 but also provide a reasonable method for calculating the eligible Gift amount. A charity that qualifies may choose to avail itself of this administrative concession. However, as tacitly stated in paragraph 11 of IC-75-23 the Exception is restricted to schools that compute the “cost per pupil” in accordance with the guidelines set out in IC-75-23. It follows that failure to respect the guidelines will result in no amount (payments made to a qualifying educational institution to allow children of the payor to attend the institution) being eligible for the Exception.

Subsection 21(1)

As mentioned earlier, the real issue does not, in our view, concern subsection 21(1). Nevertheless, you have asked whether the election under subsection 21(1) applies to registered charities and in this regard we offer the following general comments.

Briefly, subsection 248(1) defines “exempt income” to include any amount which is not included in computing a person’s income because of a provision in Part I of the Act. While Division H of Part I deals with “exempt income”, subsection 149(1) contained in that Division does not exclude from the computation of income any particular amount. Rather, subsection 149(1) commences:

No tax is payable under this Part on taxable income of a person for a period when that person was...

Thus, in the present context it would appear that the registered charity does not have “exempt income” within the meaning of subsection 21(1). With respect to the references in paragraph 20(1)(c), which would exclude interest deductions in respect of borrowed money used to acquire property the income from which would be exempt or in respect of an amount payable for property the income from which would be exempt, it is our understanding that the subject asset was acquired for the purpose of housing a school and not for the purposes of earning property income which might be “exempt income”.

Stated another way, a charity computes it’s income pursuant to the provisions of the Act, including the making of an election under subsection 21(1) where applicable, and may then rely on its exemption as a registered charity under paragraph 149(1)(f) to relieve it of any tax payable.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Legislation Access Database (LAD) on the Department’s mainframe computer. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the LAD version or they may request a copy severed using the Privacy Act criteria which does not remove client identity. Requests for this latter version should be made by you to Jackie Page at 613 957-0682. The severed copy will be sent to you for delivery to the client.

We hope our comments will be of assistance to you. If you have any questions concerning this matter please feel free to contact us.

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