Principal Issues: Interest deductibility on line of credit and on income-earning investments
Position: General comments given
Reasons: The direct use of borrowed funds is the test that predominates in determining the deductibility of interest.
XXXXXXXXXX 2009-030795 V. Srikanth March 31, 2009
Dear XXXXXXXXXX :
Re: Interest deduction
This is in response to your letter dated January 27, 2009, wherein you had requested our comments on whether interest on borrowings would be deductible, pursuant to paragraph 20(1)(c) of the Income Tax Act (the "Act"), following a restructuring of borrowings.
The relevant facts can generally be summarized as follows:
1. Currently, you and your common law spouse, have a mortgage in both your names on a vacation property.
2. Your common law spouse has non-registered savings in common stocks and mutual funds for value comparable to that of the mortgage.
3. You propose to sell the investments she holds and use the proceeds to repay the mortgage.
4. You then propose to secure a joint line of credit ("LOC"), in both your names, with either the vacation property or your principal residence as security for the LOC.
5. Using the new LOC, you propose to borrow funds to invest in a mixture of common stocks and mutual funds.
6. You further indicate that, the borrowed funds will initially be deposited in the non-registered savings account of your common law spouse.
7. You also state that none of the new investments will be identical to the ones sold earlier to avoid any superficial losses.
You are of the view that since the funds borrowed against the LOC, is for the direct use of investing, as long as no further borrowing is made against the joint LOC for purposes other than investing in a non-registered account, the interest expense should be fully deductible pursuant to paragraph 20(1)(c) of the Act, on your common law spouse's income tax return.
Our comments
Written confirmation of the tax implications inherent in particular transactions are given by this Directorate only where the transactions are proposed and are the subject of an advance income tax ruling request submitted in a manner set out in Information Circular 70-6R5. However, we do provide technical interpretations to general queries and we are prepared to provide the following comments which, as indicated in paragraph 22 of Information Circular 70-6R5, do not constitute an advance income tax ruling.
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. Furthermore, the relevant use is the current use and not the original use of the borrowed money. In determining the current use of the borrowed money, taxpayers must establish a link between the money that was borrowed and its current use.
Interpretation Bulletin IT-533, entitled Interest Deductibility and Related Issues, discusses the Agency'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.
Paragraph 15 of the Interpretation Bulletin IT-533, further states that a taxpayer may restructure borrowings and the ownership of assets, to meet the direct use test.
In The Queen v Bronfman Trust, 87 DTC 5059, the Supreme Court of Canada has stated that the onus is on the taxpayer to trace funds to a current eligible use. When borrowed money is directly applied to a given use, its use is readily determined. Decisions of the Supreme Court have introduced the concept of linking borrowed money, rather than tracing it, to its use, as well as approving of a flexible approach to tracing/linking (Tennant v. The Queen, [1996] 1 CTC 290, 1996 DTC 6121 (SCC), Shell Canada Limited v. The Queen, [1999] 4 CTC 313, 1999 DTC 5669 (SCC), The Queen v. Singleton, [2002] 1 CTC 121, 2001 DTC 5533 (SCC)). In this context, a practical approach can be used to determining the use of borrowed money and its redeployments.
With respect to borrowing money to acquire common shares, the primary issue is the income earning purpose of the share acquisition. The Supreme Court has indicated in Ludco Enterprises Ltd. et al. v. The Queen, [2002] 2 CTC 95, 2001 DTC 5505 (SCC), that the purpose test in paragraph 20(1)(c) 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). Normally, we consider interest costs in respect of funds 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. Where 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 funds and mutual fund corporations.
In the given submission, the direct use test appears to have been met. However, we do not have enough information to comment further on the interest deduction that can be claimed on the income tax return of your common law spouse. It should be noted that there are several issues to be further considered in a scenario involving a joint LOC being used by one individual including, inter alia, who is paying the interest on the LOC and whether the attribution rules apply.
We trust our comments will be of assistance to you.
Yours truly,
For Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch