10 August 1989 Internal T.I. 80297 F - Tax Avoidance - Money Borrowed for Personal Use and not for Contributing Capital to Partnership

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.

We are writing in reply to your memorandum of July 7, 1989, wherein you requested our opinion with respect to the interest deductibility on borrowed money in the following situation:

FACTS

24(1) & 19(1)

YOUR OPINION

8.     The above situation is similar to that outlined in our issue Sheet dated December 4, 1987 and is similar to that outlined in a memorandum of Tax Avoidance dated August 19, 1987.  In your opinion, the views expressed in this issue Sheet and this memorandum apparently conflict with each other and you tend to agree with Tax Avoidance's view rather than ours.

PREVIOUS OPINIONS

9.     On our Issue Sheet of December 4, 1987, we made the following general comments with respect to a situation wherein a partner borrows money from a bank, contributes it to his partnership as capital, withdraws the same amount of money from the partnership as a return of the partner's share of accumulated profit in the partnership, and then uses the money for his personal use:

a.       If the partner, instead of the partnership, borrows funds, paragraph (1)(a)(ii) of the June 2, 1987 Ways and Means Motion (the Motion) is not applicable for the interest deduction.

b.       When the Motion was drafted, it was decided that the Motion would not extend to the situation where a proprietor had a positive net worth and wanted to borrow and replace the net worth (even though the assets pertaining to the positive net worth might have been used to earn income).

c.       Because the new borrowed funds are ultimately returned to the partner, the earning capability of the partnership is not increased.  Therefore, the interest is not incurred to earn additional income from the partnership.

d.       It is equitable to adopt a general position that interest is deductible on funds borrowed to invest in a partnership to the extent of the partner's capital account (including accumulated profits).  In other words, if the partner's capital account drops to less than the borrowing as a result of distributions to the partner, interest on the excess would not be deductible.  However, borrowed funds would not be considered to be invested in a partnership if they are immediately withdrawn.

10.     On the other hand, R.N. Langridge of Tax Avoidance made the following comments in a memorandum dated August 19, 1987:

     "On June 2, 1987 the Department of Finance issued Communique 87-89 which in effect confirms the current administrative treatment of the deductibility of interest on borrowings made before 1989 of converting non-deductible interest to deductible interest...  Therefore, the partner should be allowed a deduction for interest to the extent that it replaces his equity..."

OUR OPINION

11.     In our opinion, if the transactions referred to in 2 above were in fact made on or about the same date and the withdrawn money was used for personal purposes, we would have a respectable argument that the borrowed money old not be considered to be invested in a partnership and therefore 19(1) should not be allowed to deduct the interest expense referred to in 3 above pursuant to paragraph 20(1)(c) of the Act.

     We do not believe that the Motion was intended to confirm the deductibility of interest in all situations where attempts are made to convert non-deductible interest into deductible interest.  The comments made on our Issue Sheet of December 4, 1987 remain the current administrative policy of the Department.

     Prior to the Issue-Sheet date, we issued a memorandum dated March 5, 1986 to Tax Avoidance with respect to a similar situation.  Based upon the cases Phyllis Barbara Bronfman Trust v. Her Majesty The Queen 83 DTC 5243 (FCA), and S.M.  Attaie v. MNR 85 DTC 613 (TCC), we gave an opinion that the actual use of the borrowed money is a determinant factor of interest deductibility, without referring to "the essence of the transactions".  Presumably Tax Avoidance relied on this opinion in their August 19, 1987 memorandum.  However we did not at that time have an administrative practice to allow such interest to be deductible but felt that it was the better view of the law.

     This opinion has to be modified in light of the subsequent Supreme Court of Canada decision in the Bronfman case 87 DTC 5059, in which Dickson, C.J.C., stated on page 5068 as follows:

     "If for example, the Trust had sold a particular income-producing asset, made the capital allocation to the beneficiary and repurchased the same asset, all within a brief interval of time, the courts might well consider the sale and repurchase to constitute a formality or a sham designed to conceal the essence of the transaction, namely that money was borrowed and used to fund a capital allocation to the beneficiary.  In this regard, see Zwaig v. M.N.R., 74 DTC 1121, [1974] CTC 2172 (T.R.B.), in which the taxpayer sold securities and used the proceeds to buy a life insurance policy.  He then borrowed on the policy to repurchase the securities.  Under s. 20(1)(c)(i) the use of borrowed money to purchase a life insurance policy is not a use entitling the taxpayer to an interest deduction.  The Tax Review Board rightly disallowed the deduction sought for interest payments, notwithstanding that the form of the taxpayer s transactions created an aura of compliance with the requirements of the interest deduction provision."

In our view the essence of the transactions in the case at hand is that the money was borrowed for personal use and not for contributing capital to the partnership.  Please refer to question #30 of the Panel Discussion in the 1987 Corporate Management Tax Conference, with respect to the Department's general administrative policy on converting non-deductible interest to deductible interest.

Director GeneralRulings DirectorateLegislative and IntergovernmentalAffairs Branch