26 May 2003 External T.I. 2003-0018115 - 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:

Is interest deductible on borrowed money used to acquire investments where the rate of return on the investments is lower that the interest rate on the borrowed money?

Position TAKEN:

Yes, as long as there is a reasonable expectation of income at the time the investment is made, absent a sham, window dressing or other vitiating circumstances.

Reasons FOR POSITION TAKEN:

Position released at Canadian Tax Foundation in October 2002

XXXXXXXXXX 		2003-001811
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 e-mail of April 29, 2003, and further to the telephone conversation (Moore/XXXXXXXXXX) of May 14, 2003. In particular, you have asked the following questions concerning interest deductibility on money borrowed to acquire income-producing investments.

If money is borrowed to acquire mutual funds, is the interest on the borrowed money deductible even though there is no guarantee that the mutual funds will pay dividends? If borrowed money is used to acquire a flexible term deposit or deposited in a savings account until such time as the borrowed money is invested in mutual funds, is the interest deductible on the borrowed money even though the interest expense exceeds the revenue generated from the term deposit or savings account?

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.

With respect to interest on money borrowed to acquire income-yielding investments (ex. preferred shares or guaranteed investment certificates), this issue relates to the purpose test in paragraph 20(1)(c) of the Act regarding the acquisition of a debt or equity investment that has a stated interest or dividend rate. In Ludco, the Supreme Court has indicated that the purpose test is to be 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).

In the situation you described, it is our view that generally, interest on borrowed money would be deductible if the borrowed money is invested in an income-yielding investment such as a term deposit or savings account as long as the investor has a reasonable expectation of income at the time the investment was made, absent a sham, window dressing or other vitiating circumstances.

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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