Principal Issues: Will interest on money borrowed to invest in mutual fund trust units continue to be deductible following a distribution of income from the mutual fund trust under: Scenario 1 - unit holder chooses to have all distributions of income paid to him; and Scenario 2 - unit holder chooses to have all distributions of income reinvested in the same mutual fund trust and subsequently sells exactly the same number of mutual fund trust units as were purchased through the reinvestment?
Position: Scenario 1 - Generally, yes
Scenario 2 - Depends on the current use of the money from the prorated portion of original mutual fund trust units disposed of.
Reasons: Scenario 1 - current use and original use of borrowed money remains the same.
Scenario 2 - current use vs. original use is relevant as noted in IT-533 paragraph 17.
XXXXXXXXXX 2007-023043 L. Carruthers, CA August 23, 2007
Dear XXXXXXXXXX:
Re: Interest Deductibility - Current vs. Original Use
This is in reply to your letter of April 11, 2007, wherein you asked our assistance to clarify the interest deduction that would be allowed pursuant to the Income Tax Act (the "Act") in two situations involving mutual fund trust units acquired using borrowed money which then distribute income to the unit holder by way of cash payment or reinvestment.
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. As stated in paragraph 22 of IC 70-6R5, written opinions are not advance 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 Act if it meets all the requirements of paragraph 20(1)(c) of the Act. Paragraph 20(1)(c) of the Act provides notably that the money must have been borrowed for the purpose of gaining or producing income from a business or property. It is the current use made of the borrowed money in a particular year rather than the initial use of the money, which must be considered in determining whether the interest paid or payable with respect to the borrowed money is deductible in the particular year. Therefore, in order to determine whether borrowed money has been put to an eligible use in a particular year, it is necessary to determine the current use of the original borrowed money.
We would draw your attention to our response to Q.18 at the 1984 Canadian Tax Foundation Revenue Canada Round Table, in which we stated:
"It is the Department's position, supported by several cases, including Trans-Prairie Pipelines Ltd. v. MNR, 70 DTC 6351, that interest sought to be deducted under paragraph 20(1)(c) of the Act must relate to a business or property income source. This requirement will not be satisfied in circumstances where the income source ceases to exist, is transferred, or changes use (for example, where a rental property becomes the owner's personal residence). Where one income source is disposed of and the proceeds are used to acquire another income source, interest on the borrowed money that was used to acquire the first income source will continue to be deductible to the extent that the borrowing is reflected in the cost of the new income source."
This position has been confirmed numerous times over the years. For example, you may refer to our response to Q.20 at the 1987 Corporate Management Tax Conference Report. Also note the Supreme Court of Canada decision in The Queen v. Phyllis Barbara Bronfman Trust, 87 DTC 5059, confirmed that it is the current use made of the borrowed funds in a particular year, rather than the original use of the funds, which must be considered in determining whether the interest paid or payable with respect to the borrowed funds is deductible in a particular year.
Where there is a disposition of all or any portion of the income source originally acquired with the borrowed money, it would be appropriate to consider that the income-earning purpose of the original borrowed money may no longer be met. Therefore, when the income source originally acquired with borrowed money is disposed of, the current use of the borrowed money with regard to such dispositions would need to be determined, with the other requisite interest deductibility tests applied to such use.
Scenario 1
Unit holder chooses to have all distributions of income paid to him.
Where borrowed money has been put to an eligible use and the interest on the borrowed money meets all the requirements of paragraph 20(1)(c) of the Act and the current use of the borrowed money remains unchanged (i.e., none of the property originally acquired with the borrowed money is disposed of) interest on the borrowed money will continue to be deductible for purposes of paragraph 20(1)(c) of the Act.
Generally, interest paid by an individual on a loan used to purchase mutual fund trust units is deductible provided that the interest paid satisfies all the conditions in paragraph 20(1)(c) of the Act. The fact that the income earned by the mutual fund trust is paid out to the unit holder is not relevant to determining the current use of the borrowed money.
Scenario 2
Unit holder chooses to have all distributions of income reinvested in the same mutual fund trust and subsequently sells exactly the same of number of mutual fund trust units as were purchased through the reinvestment.
The source of income acquired with a portion of the original debt has been disposed of, and, as a result, interest on the borrowed money that was used to acquire that income source will continue to be deductible only to the extent that the borrowing is reflected in the cost of a new income source.
Given the fungible nature of mutual fund trust units, specific identification methods, such as LIFO and FIFO, are generally not applicable. In our view, the proportional method (shown below) is the appropriate method of identifying what portion of the originally purchased mutual fund trust units have been disposed of in the scenario you presented.
Given the facts:
Original cost of borrowing $ 100,000 Original units purchased (say) 80,000 Income re-invested $ 3,000 Units acquired on re-investment (say) 2,400 Units subsequently disposed of 2,400
Under the proportional method, the 2,400 units subsequently disposed of would be allocated between those units purchased originally and those purchased with re-invested income as follows:
80,000 x 2,400 = 2,330 units purchased originally 82,400
2,400 x 2,400 = 70 units purchased with re-invested income 82,400
Given the above, only 97.09% ((80,000 - 2,330) / 80,000) of the source of income acquired with the original debt remains, whereas 2.91% has been disposed of. Whether or not interest on the entire $100,000 original cost of borrowing remains deductible depends on the current use of the proceeds from the 2,330 original units disposed of (the "Proceeds").
In this situation, where the Proceeds are used:
- to pay down the original borrowing, interest on the remaining borrowing would continue to be 100% deductible;
- to acquire another source of income, interest on 97.09% of the original borrowing would continue to be deductible and interest on 2.91% of the original borrowing, to the extent it is reflected in the cost of the new income source, would be deductible; or
- for personal purposes, only interest on 97.09% of the original borrowing would continue to be deductible.
We refer you to paragraph 18 of Interpretation Bulletin IT-533, entitled "Interest Deductibility and Related Issues", which offers further examples of tracing/linking borrowed money to its current use in situations where one property is replaced with another.
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