Principal Issues: [TaxInterpretations translation] Would interest on a loan used to invest in a mutual fund trust be deductible in two specific situations? In the first particular situation, the Trust makes monthly cash distributions to the individual constituting partly a return of invested capital and partly distributions of income. The individual uses the amounts received as a return of capital to pay interest on the loan and uses the amounts received as a distribution of income for personal purposes. In the second situation, the Trust makes income distributions on a monthly basis by issuing new units to the individual. Once a year, the individual disposes of a portion of the individual’s units in the Trust and use the proceeds of disposition to pay interest on the loan.
Position: General comments.
Reasons: 1) Interest on the loan could continue to be deductible to the extent that amounts received as a return of capital would be used for eligible purposes. 2) A portion of the interest on the loan could cease to be deductible at that time if the individual does not use the proceeds of disposition to acquire a new source of income or to pay an expense incurred to earn income from a business or property.
XXXXXXXXXX 2008-026851
September 24, 2008
Dear Sir,
Subject: Interest deductibility
This is in response to your letter of February 13, 2008 requesting our comments regarding the deductibility of interest in the Specific Situations described below.
Unless otherwise indicated, all legislative references herein are to the provisions of the Income Tax Act (the "Act").
Particular Situations
In the first Particular Situation, an individual borrows money ("Loan #1") to acquire an interest in a mutual fund trust ("Trust #1") having a value equal to the amount borrowed. Trust #1 makes monthly cash distributions to the individual. These distributions are partly a return of invested capital and partly distributions of income. The individual uses the amounts received as a return of capital to pay the interest on Loan #1 and uses the amounts received as an income distribution for personal purposes.
In the second situation, an individual borrows money ("Loan #2") to acquire an interest in a mutual fund trust ("Trust #2") with a value equal to the amount borrowed. Trust #2 makes monthly distributions of income by issuing new units to the individual. Once a year, the individual disposes of a portion of his units in Trust #2. The individual uses the proceeds of disposition obtained on the disposition of a portion of the individual’s interest in Trust #2 to pay interest on Loan #2.
Our Comments
It appears to us that the situations described in your letter could constitute actual situations involving taxpayers. The Canada Revenue Agency ("CRA") does not generally provide written opinions on proposed transactions otherwise than by way of advance income tax rulings. Furthermore, it is the responsibility of the relevant Tax Services Office to determine whether completed transactions have received proper tax treatment. We can, however, offer the following general comments which may not apply in full in a particular situation.
Paragraph 20(1)(c) permits a deduction in computing income for a taxation year of interest paid in the year or payable in respect of the year (depending on the method regularly followed by the taxpayer in computing the taxpayer’s income), pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from a business or property (other than borrowed money used to acquire property the income from which would be exempt or to acquire a life insurance policy), that is wholly applicable to that source of income or such part of the interest that can reasonably be considered to be applicable thereto.
Whether an interest in a mutual fund trust was acquired for the purpose of earning income is a question of fact that can only be determined after a review of all relevant facts. This determination must be made on an annual basis since it is the current use of the borrowed money rather than its original use that determines whether the interest is deductible. Furthermore, it is necessary to trace the current use of the borrowed money to a source of income from a business or property.
In the first Particular Situation, we are of the view that a direct link must be established between the borrowed money and the current use of the funds received upon repayment of the principal in order to determine whether the interest on the portion of Loan #1 corresponding to the principal repaid could continue to be deductible. This will be the case to the extent that all of the amounts received upon repayment of the principal are used for eligible purposes, the payment of an interest expense deductible under paragraph 20(1)(c) relating to a source of income generally being an eligible use.
In this case, we are of the view that the funds received upon repayment of principal would be used in part to pay the interest on the portion of Loan #1 that corresponds to the capital repaid upon the capital distribution (Repayment Portion) and in part to pay the interest on the other portion of Loan #1 that relates to the remaining interest in Trust #1. In our view, the Repayment Portion would not be used to earn income and consequently, the interest on the portion of Loan #1 corresponding to the Repayment Portion would cease to be deductible.
In the second Particular Situation, the individual's source of income would be the individual's total interest in Trust #2, i.e., the units initially acquired and the units received as part of the monthly income distributions from Trust #2. In our view, there would be a partial disposition of the individual's source of income at the time the individual disposes of a portion of the individual’s interest in Trust #2 (through the redemption of units).
A direct link must be established between the portion of the borrowed money relating to the percentage of the interest disposed of, the proceeds of disposition and the use of those proceeds of disposition. Consequently, a portion of the interest on Loan #2 could cease to be deductible if the individual does not use the proceeds of disposition to acquire a new source of income or to derive income from a business or property. In our view, the use of the proceeds of disposition to pay deductible interest expense relating to a source of income is generally an eligible use. In this case, we are of the view that a portion of the proceeds of disposition would be used to pay the interest related to the proportion of Loan #2 relating to the proceeds of disposition of a disposed-of source of income. In such a case, that portion of the proceeds of disposition would not be used to earn income and consequently, the interest on Loan #2 corresponding to that portion would cease to be deductible.
Finally, the adoption of section 3.1, as proposed by the draft amendments to the Income Tax Act presented on October 31, 2003, could have an impact on the deductibility of interest in a particular situation. Since this proposed amendment is still under review by the Department of Finance, we cannot comment on its impact with respect to interest deductibility until the Department of Finance has made the results of its review public.
We hope that our comments will be of assistance.
Best regards,
Ghislain Martineau
Manager
Financial Sector and Exempt Entities Section
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch.