Principal Issues: How to apply the tracing after a change in the use ?
Position: The relevant use is the current use and not the original use of borrowed money. If the money is used for the purpose of earning income, the interests on the loan are generally deductible even though the revenue is lower than the interest rate of the loan.
Reasons: text of the Law and jurisprudence
STEP Round Table - 2004 Annual Conference
Question 2
Interest Expense
Given recent court decisions and legislative proposals, there is now more uncertainty about the deductibility of interest expense than before. Consider a situation where a shareholder has borrowed funds from banks at different times and has used those funds for a variety of investments in a CCPC. For instance, the shareholder may have borrowed $100,000 when the CCPC was founded and put that in by way of secured loan ("loan A"). Assume the loan to the CCPC bears no interest, but the shareholder must pay 8% interest (market rate at the time of borrowing) on that loan. Later, when the business needed to expand, the shareholder borrowed a further $150,000, half of which was invested in preferred shares, and half of which was advanced as a separate loan ("loan B"). Assume that the shareholder pays only 6% interest on this loan (market rate), and that the preferred shares have a fixed dividend rate of 5%, and the loan bears interest at 6%. Later still, the shareholder borrowed another $200,000 at floating prime rate (now 3.5%), of which half was used to acquire common shares, and half was advanced as yet another secured loan ("loan C") bearing interest at prime plus 1/4%.
For each of these three distinct borrowings, there are separate loan agreements and credit facilities with the bank, with separate repayment provisions and separate interest rates.
Questions:
If the corporation were to consolidate all the loans to the shareholder into one new debt obligation, with a blended interest rate, and that interest rate resulted in "net income" (i.e. the interest income earned by the shareholder exceeded the aggregate interest expense that the shareholder paid on the three separate loan obligations), would there be any issue as the deductibility of the interest if in fact one of the loans called for interest payments at a rate greater than the blended interest rate on the consolidated debt instrument (for instance, a blended rate of 6.5%, when one loan bears interest at 8%)? If the current market rates were 4%, would this higher blended interest rate result in non-deductible interest? Would the result be different if the blended interest rate reflected current market rates, which are lower than the fixed rates on some of the earlier borrowings?
In the other words, how far does the tracing rule go?
Answer
Interpretation Bulletin IT-533, Interest Deductibility and Related Issues, dated October 31, 2003 describes the requirements in order for interest to be deductible.
Subparagraph 20(1)(c)(i) of the Income Tax Act (the "Act") requires, inter alia, that interest sought to be deducted be on "borrowed money used for the purpose of earning income from a business or property". In our view, the key issues relating to interest deductibility involve ascertaining the use of borrowed money, and identifying an income-earning purpose associated with that use.
The Courts have considered the interpretation of the term "used" and in particular whether used means first used or currently used. In this regard, several decisions by the Supreme Court of Canada, notably, Canada Safeway Ltd. v. MNR, 1957 DTC 1239, The Queen v. Bronfman Trust, 1987 DTC 5059 and Shell Canada Ltd. v. The Queen, 1999 DTC 5669 ("Shell"), have made it clear that the relevant use is the current use and not the original use of the borrowed money. Furthermore, in determining the current use of the borrowed money, taxpayers must establish a direct link between the money that was borrowed and its current use. However, we may apply the indirect use test in certain circumstances as exceptions to the direct use test. Paragraphs 22 to 26 of IT-533 discuss these exceptions.
In simple situations where one property is replaced with another, such linking is straightforward. In these situations, 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.
Borrowings to acquire income-yielding investments must meet the income earning purpose test in subparagraph 20(1)(c)(i) of the Act. In its decision in Ludco Enterprises Ltd. v. The Queen, 2001 DTC 5505, the Supreme Court indicated that that purpose 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). It also mentioned that income in subparagraph 20(1)(c)(i) of the Act refers to income that is generally income that would be taxable and not net income. In applying this test, it is the Agency's view that interest on money borrowed to acquire an investment that has a stated rate of income will generally be fully deductible under paragraph 20(1)(c) of the Act. As a consequence, interest will neither be denied in full nor restricted to the amount of income from the investment.
In considering whether or not an interest rate is reasonable, consideration will be given to prevailing market rates for debts with similar terms and credit risks. Further, as stated in Shell, "Where an interest rate is established in a market of lenders and borrowers acting at arm's length from each other, it is generally a reasonable rate..."
Under the debt consolidation, the shareholder receives a new interest bearing investment in exchange for loans A, B and C. The new investment is the current use of the money originally borrowed to acquire loans A, B and C. Since this investment is an income producing property, the interest on the money originally borrowed will be deductible under paragraph 20(1)(c) of the Act.
We also wish to inform you that on October 31, 2003 the Department of Finance released for public comment draft proposals regarding the deductibility of interest and other expenses related to a source. The proposals include rules that require that there be a "reasonable expectation of cumulative profit" from a source that is a business or property for a taxation year in order to report the loss realized from the business or property. These new rules, if they are enacted, will be applicable to taxation years beginning after 2004. These proposed rules would not affect the deductibility of the interest under paragraph 20(1)(c) of the Act because it is an expense that is deductible in the computation of the income or the loss from a source. However, the loss realized from a source that is a property or a business may be denied under the draft proposals.
June 7, 2004
2003-006994