20 April 2009 External T.I. 2009-0309811E5 - Interest deductibility - 20(1)(c)

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.

Principal Issues: Is an amount deductible as "interest" on borrowings from an Islamic institution, pursuant to paragraph 20(1)(c) of the Act, where the lender charges the amount as "Rental payments" instead of interest

Position: Unable to determine in the context of an interpretation request

Reasons: Depends on the facts of the case- should be determined in the context of a ruling request

XXXXXXXXXX
			2009-030981
			V. Srikanth

April 20, 2009

Dear XXXXXXXXXX :

Re: Interest deduction

This is in response to your e-mail dated February 12, 2009, wherein you had requested our comments on whether or not rental payments, in lieu of interest, would be considered an acceptable deduction, pursuant to paragraph 20(1)(c) of the Income Tax Act (the "Act"). You specifically wanted to know whether an amount paid on borrowings through an Islamic institution, rather than a financial institution, will constitute interest, for the purpose of deduction pursuant to paragraph 20(1)(c), where the Islamic institution will charge amounts as "rental payments" instead of interest payments.

Our Comments

Written confirmation of the tax implications inherent in particular transactions are given by this Directorate only where the transactions are proposed and are the subject of an advance income tax ruling request submitted in a manner set out in Information Circular 70-6R5. However, we do provide technical interpretations to general queries and we are prepared to provide the following comments which, as indicated in paragraph 22 of Information Circular 70-6R5, do not constitute an advance income tax ruling.

"Interest" is not defined in the Act but has been addressed in several court decisions, including Shell Canada Limited v. The Queen, [1999] 4 CTC 313, 1999 DTC 5669 (SCC) ("Shell"), The Queen v. Sherway Centre Ltd., [1998] 2 CTC 343, 1998 DTC 6121 (FCA) ("Sherway") and Miller v. The Queen, [1985] 2 CTC 139, 1985 DTC 5354 (FCTD)("Miller").

In Miller, Reed J. made the following comment about interest:

"It is common ground that the Income Tax Act does not define interest and that the various sections dealing with interest therein (12(1)(c); 110.1(1); 110.1(2); 110.1(3)(ff)), either deeming, or excluding certain amounts for certain purposes as interest are of little assistance. One must look to the general principles of interpretation, dictionary definitions and the jurisprudence. In this regard the meaning of the word "interest" in ordinary parlance is significant."

In Miller, the court has established three criteria for amounts to be considered as interest:

1) It must be compensation for the use of a principal sum or the right to a principal sum.
2) It must be calculated on a principal sum or a right to a principal sum.
3) It must be calculated on an accrual (day to day) basis.

Paragraph 3 of the Interpretation Bulletin, IT-533, entitled "Interest Deductibility and Related Issues", explains that "where a contract or arrangement does not explicitly identify any amount as interest but an amount can reasonably be regarded as interest, that amount is deemed to be interest under section 16 of the Act."

In Shell, Judge Linden, commented that, "The determination of what is interest is always a question to be ultimately decided by the court. Something is not interest merely because the parties agree to call it interest." By the same token, something will not be considered not to be interest, just because the parties agree to call it otherwise.

Linden J.A. further, made the following comment with respect to the decision in MNR v Groulx 66 DTC 5126; [1966] CTC 115:

"By characterizing the entire purchase price as not including interest on the outstanding balance, the taxpayer was seeking to avoid paying tax on the interest portion, because at that time, capital gains on the disposition of the land were tax-free. The Supreme Court of Canada affirmed the decision of Justice Kierney of the Exchequer Court, who held that the purchase price included a capitalization of interest payments that ought properly to be included in income."

Further, once an amount has been established to be "interest", it will have to be determined if it qualifies as an interest expense within the meaning provided in paragraph 20(1)(c) of the Act.

Pursuant to paragraph 20(1)(c) of the Act, a taxpayer may deduct:

An amount paid in the year or payable in respect of the year (depending on the method regularly followed by the taxpayer in computing the taxpayer's income), pursuant to a legal obligation to pay interest on:

i. borrowed money used for the purpose of earning income from a business or property (other than borrowed money used to acquire property the income from which would be exempt or to acquire a life insurance policy),

ii. an amount payable for property acquired for the purpose of gaining or producing income from the property or for the purpose of gaining or producing income from a business (other than property the income from which would be exempt or property that is an interest in a life insurance policy), or a reasonable amount in respect thereof, whichever is the lesser.

In Shell, Linden J.A. stated the four conditions that a borrower must satisfy in order to be able to deduct amounts claimed as interest. They are:

1. The amount must be paid in the year (or be payable in the year, depending on which method of accounting the taxpayer uses).
2. It must be paid pursuant to a legal obligation to pay interest on borrowed money.
3. The money must be used for the purpose of earning income from a business or property (not including exempt income).
4. The rate of interest must be reasonable.

Hence, in the given instance, for the purposes of deducting as an interest expense, first it will have to be established whether the amount paid on borrowings from an Islamic Institution constitutes "interest", and then it will have to be determined whether such interest amount falls within the purview of paragraph 20(1)(c) of the Act. As previously noted, the name given to a transaction does not decide its nature.

Lastly, whether an amount is "interest", and whether it qualifies for the deduction provided for in paragraph 20(1)(c) of the Act, is a question of fact which can only be determined following a thorough analysis of all relevant documents and agreements between the parties involved. Your enquiry, in our view, would best be dealt with in the context of an advance income tax ruling request such that we would have the opportunity to fully review all of the facts and relevant agreements.

We trust our comments will be of assistance to you.

Yours truly,

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