26 May 2003 External T.I. 2003-0012425 - 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.

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

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

Principal Issues:

An individual takes out a loan that is secured by a mortgage on his principal residence. The loan proceeds are invested in mutual funds. The individual sells his principal residence and is required by the lender to repay the loan out of the proceeds of the sale of the home. The individual purchases another principal residence, using the funds from two new loans to fund the purchase. The first new loan is equal in amount to the loan repaid by the sale. The second new loan covers the balance of the purchase price of the new home. Both loans are secured by mortgage on the new home. The issue is whether the interest paid on the first new replacement loan is deductible under paragraph 20(1)(c) of the Act.

Position TAKEN:

The borrowed money (i.e., first and second new loans) was used to acquire a principal residence and this is an ineligible purpose for purposes of paragraph 20(1)(c) of the Act. It is not possible to trace the borrowed money (first and second loans) to a current eligible use. However, in Grenier, the Court found that there were exceptional circumstances, as referred to in Bronfman Trust, were present. Whether the situation described is similar to the circumstances in the Grenier case is a question of fact.

Reasons FOR POSITION TAKEN:

Exceptional circumstances doctrine in Bronfman Trust. See 2002-0156565.

XXXXXXXXXX 		2003-001242
G. Moore
May 26, 2003

Dear XXXXXXXXXX:

Re: Paragraph 20(1)(c) of the Income Tax Act (the "Act")

This is in reply to your letter of April 2, 2003, concerning interest deductibility on money borrowed to acquire mutual funds.

You have asked for our comments in the following situation:

An individual takes out a loan that is secured by a mortgage on his principal residence. The loan proceeds are used entirely to invest in a portfolio of mutual funds. The portfolio is periodically rebalanced whereby the portfolio manager sells a portion of the mutual funds which have gained in value and buys more of the funds which have declined. The individual sells his principal residence and is required by the lender to repay the loan out of the proceeds of the sale of the home. The individual purchases another principal residence, using the balance of the proceeds of the sale, savings, and funds from two new loans to fund the purchase. The first new loan is equal in amount to the loan repaid by the sale. The second new loan covers the balance of the purchase price of the new home. Both loans are secured by mortgage on the new home. The issue is whether the interest paid on the first new replacement loan is deductible under paragraph 20(1)(c) of the Act.

Our Comments

It appears that the situation you describe concerns a completed or proposed transaction and therefore, we are unable to provide any confirmation of the tax consequences except, with respect to a proposed transaction, in the context of an advance income tax ruling. Confirmation of the tax consequences respecting a completed transaction must be obtained from the local tax services office. We can offer, however, the following general comments.

Subparagraph 20(1)(c)(i) of the Act allows a deduction for interest on borrowed money used for the purpose of earning income from a business or property. As you know, on October 1, 2002, we presented at the Canadian Tax Foundation an update on our preliminary review of our existing interpretative and administrative positions on interest deductibility. One of these positions related to the deductibility of interest with respect to money borrowed to purchase common shares. The primary issue is the income earning purpose of the share acquisition. The purpose test is applied as follows: Considering all the circumstances, did the taxpayer have a reasonable expectation of income at the time the investment was made (absent a sham, window dressing or other vitiating circumstances). Normally, we consider interest costs in respect of funds borrowed to purchase common shares to be deductible on the basis that there is a reasonable expectation (at the time the shares are acquired) that the common shareholder will receive dividends. However, it is conceivable that in certain fact situations, such reasonable expectation would not be present. Where evidence from corporate officials indicates that dividends are not expected to be paid and that shareholders are required to sell their shares in order to realize their value, the purpose test would likely not be met. Such a situation would not be expected to be commonplace. Where, however, a corporation is silent with respect to its dividend policy, or where the dividend policy is that dividends will be paid when operational circumstances permit, the purpose test will likely be met. However, each situation must be dealt with on the basis of the particular facts involved. The foregoing comments are also generally applicable to investments in mutual fund trusts and mutual fund corporations.

If mutual funds are acquired using borrowed money and assuming that the interest on the borrowed money to acquire the mutual funds is deductible, generally, the interest on the borrowed money would continue to be deductible if the individual sold the mutual funds and replaced them with other income-earning investments during the period the loan is outstanding. It is the current use of the borrowed money that is relevant. The collateral (ex. a principal residence) used to acquire borrowed money is not a relevant factor in determining whether interest on borrowed money is deductible under paragraph 20(1)(c) of the Act.

In your example, the borrowed money used to acquire the mutual funds is repaid. Two new loans are taken out and are used to acquire a new principal residence. The borrowed money (i.e., first and second new loans) was used to acquire a principal residence and this is an ineligible purpose for purposes of paragraph 20(1)(c) of the Act. It is not possible to trace the borrowed money (first and second loans) directly to a current eligible use.

However, we wish to bring to your attention the findings of the Federal Court -Trial Division in Her Majesty the Queen v. Pierre Grenier, 98 DTC 6439. In Grenier, the taxpayer obtained a bank loan ("first loan") of $65,625 guaranteed by a mortgage on his principal residence and he advanced the borrowed money interest free to C Inc., a corporation of which he was the principal shareholder. The taxpayer subsequently liquidated shares of another corporation and advanced proceeds of $90,194 interest free, to C Inc. The taxpayer sold his principal residence and discharged the first loan. He obtained another bank loan for $151,700 to assist him in obtaining a principal residence. At issue was whether the taxpayer was entitled to deduct interest on borrowed money of $65,625 of the $151,700 loan. In Grenier, Justice Pinard, J. of the Federal Court - Trial Division wrote:

"In this case, I am of the opinion that there are exceptional circumstances in which, on a real appreciation of the taxpayer's transactions, it is appropriate because of the indirect effect on his capacity to earn income from his business in Hull, to allow him to deduct the interest on the funds borrowed for an ineligible purpose, the purchase of his new residence in Gatineau. Considering the economic context of the transactions and the concurrence of the events, I am quite satisfied that the defendant's real purpose in using the funds in question was to earn income. In my view the exceptional circumstances referred to in Bronfman Trust, supra, at page 54, are present in this case."

Whether the situation you described is similar to the circumstances in Grenier is a question of fact.

On February 18, 2003, as part of the presentation of the Federal budget, the Department of Finance published the following statement concerning the deductibility of interest:

"Recent court decisions have raised uncertainties as to how taxpayers are to treat expenses, in particular interest, in computing income from a business or property for purposes of the Income Tax Act. Most notably, these decisions could lead to inappropriate tax results where a taxpayer derives a tax loss by deducting interest expenses, even if under any objective standard there is no reasonable expectation that the taxpayer would earn any income (as opposed to capital gains), or where the presence or the prospect of revenue (as opposed to income net of expenses) is enough to conclude that an expenditure was incurred "for the purpose of earning income".

Neither of these results is consistent with appropriate tax policy, nor would they have been generally expected under prior law and practice. Therefore legislative amendments to the Income Tax Act will be considered in order to provide continuity in this important area of the law. Before finalizing any proposals, however, the Department of Finance will release them for public consultation, with a general goal of ensuring that they restore continuity with the expected consequences before these recent court decisions."

We trust that these comments will be of assistance.

Yours truly,

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

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