3 February 1989 Income Tax Severed Letter

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.

February 3, 1989

TO EDMONTON DISTRICT OFFICE E.J. Scherman Chief of Audit

     Attention:  D. Zimmerman
                 Business Audit

FROM HEAD OFFICE Rulings Directorate R.P Laramy

SUBJECT  XXXX                                     
         1984 and 1985 Taxation Years

This is in reply to your memorandum of May 31, 1988, wherein you asked for our assistance in interpreting and applying subsection 18(2) and paragraphs 20(1)(c) 53(1)(h) and 52(3)(m) of the Income Tax Act.

The facts as we understand them are as follows:

1. XXXX

2. XXXX

3. XXXX

4. XXXX

6. XXXX

7. XXXX

8. XXXX

9. XXXX

Your Position

With respect to the XXXX property, it is your view that the land was not used or held in XXXX business, as it did not form part of the rental operation during the years it was owned by XXXX and no development of the land was undertaken.

In your view, the interest is not deductible by virtue of subsection 18(2), as neither of the exceptions in paragraphs 18(2)(c) or (e) are applicable. You have proposed to delete the XXXX of accrued interest from the adjusted cost base of the XXXX property, since interest which is not deductible by virtue of subsection 18(2) can only be added to the cost of the land pursuant to paragraph 53(1)(h) if it is paid. Since the XXXX, was extinguished without payment, you have determined that the adjusted cost base (A.C.B.) adjustment in paragraph 53(1)(h) is not available to XXXX.

With respect to the XXXX property, it is our view that paragraph 53(2)(m) prevents XXXX from adding interest, which is otherwise deductible under paragraph 20(1)(c), to the cost thereof. Accordingly, you have proposed to reduce the adjusted cost base of that property by the XXXX of capitalized interest.

Taxpayer's Position

It is XXXX view that the XXXX property was held in the course of its business, which business is the development of properties for rental purposes. Accordingly, it is XXXX opinion that subsection 18(2) is not applicable by virtue of the exemption in paragraph 18(2)(c) XXXX contends that the interest is otherwise deductible under paragraph 20(1)(c) and is capitalized in accordance with Generally Accepted Accounting Principles (GAAP). They feel the correct tax treatment is to reduce the capital gain realized on the disposition of the XXXX property by the accrued interest.

XXXX stating once again that the interest is otherwise deductible under paragraph 20(1)(c) and is capitalized in accordance with GAAP.

Our Position

1. Subsection 18(2) was amended by 1988, C.55, S. 10(6), applicable to the 1988 and subsequent years. Our comments herein refer to subsection 18(2) as it applies to the particular years involved in this case.

2. Subsection 18(2) can only be applied to disallow an interest expense if the interest is otherwise deductible.

From the information provided to us, it is evident that a portion of the XXXX

In our view, interest on money borrowed specifically for the purpose of paying previously unpaid interest (referred to hereinafter as "secondary interest") cannot be regarded, in a strict sense, as being used directly for the purpose of earning income (by analogy, see Interior Breweries Ltd. v. M.N.R., 55 DTC 1090, (Exch. Ct.) at p. 1093, where, for taxation years prior to the enactment of subsection 11(3)(b) (currently subsection 20(3)), it was held that interest money borrowed to repay previous borrowings was not deductible as the borrowed funds were used to repay a loan and not to earn income.) The direct purpose test was upheld as a criterion for interest deductibility under subparagraph 20(1)(c)(i) in The Queen v. P.B. Bronfman Trust, 87 DTC 5059 (SCC), and as such, we feel a respectable argument can be made that secondary interest is a non-deductible expense for the purposes of the Income Tax Act.

Despite the latter comments, we generally do not disallow the deduction of secondary interest, particularly if the primary interest to which it relatesis in respect of funds that continue to be used by the taxpayer to earn income.

XXXX

It is only interest disallowed by virtue of subsection 18(2) which can be added to the cost of the land pursuant to paragraph 53(1)(h); see for example H. Baverle v. M.N.R., 86 DTC 1131 (TCC) J. Heard v. M.N.R., 86 DTC 1573 (TCC).

3. Subsection 18(2) deals with interest on debt which relates to the acquisition of land. From the information provided to us, it would appear a XXXX. Subsection 18(2) would not be applicable to this portion of the accrued interest. Furthermore XXXX would have no justification for adding this portion of the accrued interest to the cost of the land. In our view, if this interest otherwise meets the criteria in paragraph 20(1)(c), then it would be deductible in the years in which it became payable.

4. Subsection 18(2) does not apply, if in the year in question, the land can reasonably be considered to have been used in, or held in the course of, a business carried on by the taxpayer. In our view, the facts of each particular case would determine whether or not a taxpayer is carrying on a business in a particular year, and whether or not the land is being used or held in the course of that business.

If a taxpayer is actively developing vacant land for rental purposes, and his rental operations do indeed qualify as a business, then subsection 18(2) would probably not apply. However, there can be periods of inactivity in any business; consider for example the comments in Carland (Niagra) Ltd. v. M.N.R., 64 DTC 139 (TAB), ar 141, where it was stated:

"It is not necessary that there be sustained activity before it can be maintained that a business is carried on; there may be and often are periods of quiescence in almost any business enterprise."

Also refer to the Queen v. Dorchester Drummond Corp. Ltd., 1979 DTC 5164 (FCTD), where it was held that a taxpayer was carrying on a business, partly due to the fact that the taxpayer had not abandoned all hope of developing vacant land which had been bought and held for several years. In this regard, it is our view that a taxpayer need not be actively developing the land in order to avail himself to the exemption in paragraph 18(2)(c). Indeed, this latter exception applies to land that is "held" as well as land "used" in a business.

In determining whether land is "held in the course of business", we have generally taken the view that this expression, as used in paragraph 18(2)(c), indicates that the holding of vacant land should be one of a succession of events involved in conducting the activities of the particular business. This interpretation is consistent with the meaning given to the phrase "in the course of" in Blok-Anderson v. M.N.R., 72 DTC 6309 at 6321, (FCTD). In this context, we have attempted to apply subsection 18(2) in situations where the holding of vacant land is considered to be incidental to the normal business activities of a taxpayer, or where it is clearly evident that the development of the land could not be expected to occur for many years in the future, if at all.

Based on the information available to us, it is difficult to formulate a conclusive opinion as to whether or not subsection 18(2) should be applied. In the situation described here

XXXX

5. We agree that the A.C.B. adjustment in paragraph 53(1)(h) is only available if the interest described in that paragraph is actually paid. Accordingly, for any accrued but unpaid interest, which is disallowed by virtue of subsection 18(2), no paragraph 53(1)(h) adjustment is available.

6. In respect of the XXXX mortgage, if the interest is otherwise deductible under paragraph 20(1)(c) and is not disallowed by subsection 18(2), it seems to us that it should have been deducted in the years in which it became payable. We are unable to find support for XXXX position that interest, which is capitalized in accordance with GAAP, should form part of the tax cost of land held as a capital property.

XXXX

7. We confirm the comments made in our telephone conversation (Laramy/ White, December 14, 1988) that it appears to us based on the information available that an argument could be made the XXXX property was in fact held by XXXX as inventory rather than as a capital property. It is not uncommon for land developers to hold land as inventory prior to changing the use to a capital property. Useful comments in this regard can be found in IT 102R2, IT 281R and IT 153R2.

8. Our comments in point 6 dealing with the capitalization of interest on the XXXX mortgage are also applicable to the interest on the XXXX mortgage. In the XXXX case, however, there are various provisions of the Act which may provide justification for capitalizing the interest. Subsection 18(3.1) may apply (unless you determine that XXXX is a company described in subsection 18(3.4) or section 21 may be applicable (if you accept XXXX treatment of the interest as a section 21 election - see IT 121R2, paragraph 9). Paragraph 53(2)(m) would not apply in such circumstances.

If it is determined that neither subsection 18(3.1) nor section 21 is applicable, then it would appear the interest which is otherwise deductible under paragraph 20(1)(c) should have been deducted in the years in which it became payable.

XXXX

Our comments in point 1 with respect to secondary interest and our comments in point 2 with respect to funds used by XXXX for other purposes, are equally applicable in the XXXX case as well.

We trust our comments will be of assistance to you.

Chief Financing & Leasing Section Financial Industries Division