Principal Issues: Where the market value of a property acquired with borrowed money has increased since the time of acquisition, would the interest continue to be deductible when a taxpayer disposes of all or a portion of the property under: Scenario 1 - 100% of the property is disposed of, the original borrowing is paid off, a new borrowing is entered into and new units of the same property are acquired; or Scenario 2 - a portion of the property, reflecting the capital growth of the property, is disposed of resulting in the remaining property having a market value equal to the original borrowing?
Position: Scenario 1 - Generally, yes.
Scenario 2 - Depends on the current use of the money from the prorated portion of original 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 paragraphs 17-18.
XXXXXXXXXX 2007-023034 L. Carruthers, CA September 10, 2007
Dear XXXXXXXXXX:
Re: Interest Deductibility - Current vs. Original Use
This is in reply to your letter of April 10, 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 hypothetical situations involving mutual fund trust units (shares of a mutual fund corporation or shares listed on the TSX), acquired using borrowed money, which increase in market value following their acquisition. You state in your submission that the original borrowed money and the original property meet all the conditions listed in paragraph 20(1)(c) of the Act.
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 IC-70-6R5. As stated in paragraph 22 of IC-70-6R5, technical interpretations 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 ("Trans-Prairie Pipelines"), 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
100% of the property is disposed of, the original borrowing is paid off, a new borrowing is entered into and new units of the same property are acquired.
As noted in paragraph 18 of Interpretation Bulletin IT-533, entitled "Interest deductibility and Related Issues", in simple situations where one property is replaced with another, the current use of the borrowed money is entirely with respect to the replacement property since all the proceeds of disposition from the original property are reinvested in the replacement property. Accordingly, if all of the requisite deductibility tests are met with respect to the new property, all of the interest would be deductible with respect to that use.
In Scenario 1 of this hypothetical situation, 100% of the property is disposed of and all of the proceeds from that disposition are used to pay off the original borrowing. Therefore the original borrowing no longer exists and it is the current use of the new borrowed money that must be ascertained. Accordingly, if all of the requisite deductibility tests are met with respect to the new property, all of the interest would be deductible with respect to the new borrowed money.
Scenario 2
A portion of the property, reflecting the capital growth of the property, is disposed of resulting in the remaining property having a market value equal to the original borrowing.
The source of income acquired with a portion of the original borrowing 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 (shares of a mutual fund corporation or shares listed on the TSX), 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 Market value per unit (say) $ 1 Original units purchased 100,000
Subsequent market value per unit $ 1.30 Subsequent value of original units $ 130,000
Original units subsequently disposed of 23,077 Market value of original units disposed of $30,000
Original Units remaining 76,923 Market value of remaining original units $ 100,000
Given the above, only 76.923% ((100,000 - 23,077) / 100,000) of the source of income acquired with the original borrowing remains, whereas 23.077% 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 23,077 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 76.923% of the original borrowing would continue to be deductible and interest on 23.077% 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 76.923% of the original borrowing would continue to be deductible.
Paragraph 18 of IT-533 offers further examples of tracing/linking borrowed money to its current use in situations where one property is replaced with another. Specifically, Example 5 discusses how the flexible approach to linking may be applied in circumstances when property is disposed of at a gain and the proceeds are used to acquire more than one property.
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