21 April 2010 External T.I. 2009-0352171E5 - 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.

Principal Issues: Is mortgage interest deductible pursuant to paragraph 20(1)(c) of the Act in a restructured borrowing arrangement ?

Position: Appears so.

Reasons: Direct use of borrowed money for income producing purpose can be identified. The arrangement is very similar to the one proposed by Hershfield J. in Sherle v The Queen.

XXXXXXXXXX 								V. Srikanth
									2009-035217
April 21, 2010

Dear XXXXXXXXXX :

Re: Interest deductibility

This is in response to your letter dated December 17, 2009, wherein you requested our views regarding the interest deductibility on a particular loan restructuring arrangement.

Specifically, you have described a situation wherein an individual proposes to sell his primary residence to his parents at fair market value. He receives a promissory note ("PN") as consideration. The individual then plans to buy back the house from his parents, to use as a rental property, by taking a mortgage on the property. The parents use the proceeds to pay off the PN. The individual then uses the re-acquired property for rental purposes and plans to buy a new property for his principal residence.

You would like us to comment whether the interest paid on the mortgage will be eligible for deduction pursuant to paragraph 20(1)(c) of the Income Tax Act (the "Act"). We had conveyed our views to you over the telephone on March 2, 2010. You, however, requested that we send you a written response.

Our Comments

Written confirmation of the tax implications inherent in actual proposed transactions is given by this Directorate only where the transactions are the subject of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R5, entitled Advance Income Tax Rulings. This Information Circular and other Canada Revenue Agency ("CRA") publications can be accessed on our website at http://www.cra-arc.gc.ca. If, however, the particular transactions are completed or partially completed, the enquiry should be addressed to the relevant Tax Services Office. Your request was not submitted as an advance income tax ruling request. However, as stated in paragraph 22 of IC 70-6R5, we do provide written opinions on general enquiries which are not advance income tax rulings and are not binding on CRA, and we are, accordingly, prepared to provide you with the following comments.

Subparagraph 20(1)(c)(i) permits the deduction of an amount paid in the year or payable in respect of the year, pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from a business or property. In general, the test to be applied for the use of borrowed money is the direct use of the borrowed money and it must be done giving effect to the legal relationships.

Interpretation Bulletin IT-533, entitled Interest Deductibility and Related Issues, discusses the CRA's interpretations of the deductibility of interest expense under various provisions of the Act and the judgments in numerous court decisions involving the deductibility of interest expense. The courts have determined that it is the direct use to which the borrowed money is applied which governs whether the interest is deductible for tax purposes. However, as indicated in paragraph 13 of IT-533, under certain circumstances, the courts have stated that indirect use will be accepted as an exception to the direct use test. In determining what borrowed money has been used for, the onus is on the taxpayers to trace or link the borrowed money to a specific eligible use, giving effect to the existing legal relationships.

Further, paragraph 15 of IT-533 states that a taxpayer may restructure borrowings and the ownership of assets to meet the direct use test. The situation described above is very similar to the one described by Hershfield J. in Sherle v The Queen, 2009 TCC 377 ("Sherle"). When analyzing the borrowing arrangement on a home that the appellant co-owned with her husband and converted from their principal residence to a rental property, Hershfield J. made the following comments, explaining how the appellant could have possibly arranged her affairs in order for interest to be deductible on the borrowed funds:

"Indeed, the Appellant argued, without particular knowledge of the plan in Singleton [Singleton v The Queen, (2001) 2 S.C.R. 1046], that she could have sold the residence to a friend and bought it back and achieved the desired result. For example, with the necessary legal advice, the Appellant might have done something along the following lines:

• On day 1 she sells her residence, the Joyce Property, to her friend Ms. A. The purchase price is paid by issuing a Promissory Note;
• On day 2 she takes a bank loan to discharge the mortgage on the Ewart Property (the first loan). While the loan might only be a daylight-bookkeeping entry, there is adequate security for it given that a collateral charge will be immediately available on the Ewart Property upon the payout of the former charge against it;
• Also on day 2, she buys back the Joyce Property (her new rental property), and finances this acquisition by borrowing money from the bank, which loan is secured by a mortgage on the re-acquired property (the second loan);
• The proceeds of the latter mortgage are paid to her friend Ms. A as consideration for this buy-back and Ms. A uses the proceeds to pay off the Promissory Note she issued on the purchase of the property the day before;
• The proceeds from the Promissory Note are used by the Appellant to pay off the first bank loan;
• The only remaining loan is the second loan taken to acquire a rental property;
• Everything is done at fair market value without tax consequence, and actual transfers of land need never be registered.

Since in this hypothetical scenario the direct use of the borrowed funds would be to buy the rental property, applying the Singleton test of direct use would most likely result in the interest on such borrowing being deductible."

The restructuring described in your submission appears to be very similar to the one described by Hershfield J. in Sherle and one which the court considered would likely be acceptable for the purpose of interest deductibility pursuant to paragraph 20(1)(c) of the Act. Hence, in our view, after the restructuring described in the scenario in your submission, the direct use test appears to be met such that the individual should be eligible to claim an interest deduction pursuant to subparagraph 20(1)(c)(i) of the Act.

We trust our comments will be of assistance to you.

Yours truly,

R.A. Albert, CA
For Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch