Principal Issues: Will interest on borrowed money, used for the purpose of investing in income producing assets, be deductible, where the income earned from the investments may be less than that interest expense.
Position: As noted in paragraph 10 of IT 533, income earned need not be in excess of interest paid, but must consider draft section 3.1 of the Income Tax Act.
Reasons: Until the Department of Finance's review of the October 2003, legislative proposals is complete and the results are made available to the public, we cannot comment further on their impact on interest deductibility.
XXXXXXXXXX 2008-027517 L. Carruthers, CA April 24, 2008
Dear XXXXXXXXXX :
Re: Interest Deductibility
This is in reply to your letter of April 18, 2008, wherein you asked our technical interpretation of whether the interest on borrowed money, used for the purpose of investing in income producing assets, would be deductible, where the income earned from the investments may be less than that interest expense.
Our Comments
It appears that the situation outlined in your letter involves an actual fact situation relating to a proposed transaction. Written confirmation of the tax implications inherent in an actual proposed transaction are given by this Directorate only where the transactions are the subject of an advance income tax ruling request submitted in a manner set out in Information Circular IC-70-6R5. As stated in paragraph 22 of IC-70-6R5, technical interpretations are not income tax rulings and, accordingly, are not binding on the Canada Revenue Agency (the "CRA"). The following comments are, therefore, of a general nature only.
Interest on borrowed money is deductible for purposes of the Income Tax Act (the "Act") if it meets all the requirements of paragraph 20(1)(c) of the Act. One such requirement is that the borrowed money must be used for the purpose of earning income from a business or property. For an understanding of the term 'income' in the context of paragraph 20(1)(c), we would draw your attention to our comments in paragraph 10 of Interpretation Bulletin IT-533, Interest Deductibility and Related Issues, which addresses the Supreme Court's decision in Ludco Enterprises Ltd., [2002] 1C.T.C. 95 (SCC):
"The interpretation of the term income was addressed in Ludco as follows: "...it is clear that 'income' in s. 20(1)(c)(i) refers to income generally, that is an amount that would come into income for taxation purposes, not just net income." The court also said, "The plain meaning of s. 20(1)(c)(i) does not support an interpretation of 'income' as the equivalent of 'profit' or 'net income' .... Therefore, absent a sham or window dressing or similar vitiating circumstances, courts should not be concerned with the sufficiency of the income expected or received.""
However, notwithstanding the above, we would bring to your attention the following Department of Finance statement concerning the deductibility of interest and other expenses which was published on February 23, 2005, as part of the presentation of the Federal budget:
"In October 2003, the Department of Finance released for public consultation a package of legislative proposals regarding the deductibility, for income tax purposes, of interest and other expenses. The proposals responded to certain court decisions that departed significantly from what had been the accepted understanding of the law in this area. [notably Ludco Enterprises Ltd., [2002] 1C.T.C. 95 (SCC) - ed.]
In computing income from a business or property, a taxpayer can deduct many kinds of expenses, provided they were incurred in order to earn the income. A familiar example is interest on borrowed money, which is deductible only if the borrowed money is used for the purpose of earning income from a business or property.
In this context, "income" had been understood to be a net amount comparable to profit, and to exclude capital gains. The court decisions, however, took a different view: income was read as the equivalent of gross revenue, and the distinction between income and capital gains was blurred.
The 2003 proposals were intended to restore the law on these points to its more familiar and more appropriate state.
An extended period of public consultation on the proposals ended in August 2004. Many commentators expressed concerns with the proposals' structure: in particular, that the proposals' codification of an objective "reasonable expectation of profit" test might inadvertently limit the deductibility of a wide variety of ordinary commercial expenses. The Department of Finance has sought to respond by developing a more modest legislative initiative that would respond to those concerns while still achieving the Government's objectives. The Department will, at an early opportunity, release that alternative proposal for comment. This will be combined with a Canada Revenue Agency publication that addresses, in the context of the alternative proposal, certain administrative questions relating to deductibility."
It is our understanding that the Department of Finance continues to receive submissions on interest deductibility and the draft legislation and intends to address the concerns raised prior to enacting it. Furthermore, it is our understanding that once enacted, the legislation will be applicable to taxation years that begin after 2004.
We trust that our comments will be of assistance.
Yours truly,
R.A. Albert, CA
For Director
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate