19 December 2000 Internal T.I. 2000-0060077 - ELECTION AND INTEREST DEDUCTION

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

Subsection 39(4), interest deduction

Position TAKEN:

Subsection 39(4) election could be available depending of the situation and the interest deduction would not be available.

Reasons FOR POSITION TAKEN:

A non-arm's length transfer of shares to a child categorized them as prescribed securities and gift to child of shares is a non eligible use for section 20.1 relief.

		December 19, 2000

	MONTREAL TSO	HEADQUARTERS
	1208-471-1-0	Yves Leclerc
(613) 957-2744
	Attention: Carole Sicotte
		2000-006007

Subsection 39(4) election & interest deduction

This is in reply to your memorandum dated November 28, 2000 in which you seek clarification concerning the Canada Customs & Revenue Agency's (the "Agency") positions on two (2) related issues. The issues are as follows: (1) whether or not a minor child or a trustee for a minor child can make an election under subsection 39(4), (2) whether interest expenses are still deductible following the borrower's (Grand-parent's) transfer to a minor of the properties for which the borrowing was used.

Our comments

Issue 1:

At the 1984 Canadian Tax Foundation Conference, an answer to that issue was given as follows:

We regard an election as valid only if it is made by a person who is legally competent. Where a taxpayer, because of his infancy, is unable to make a preferred beneficiary election, another person may make the election on his behalf. In our opinion, that person is the person who has been appointed as his guardian or, in the absence of such an appointment, the person described in paragraph 150(1)(d) of the Act who will file his return of income. In any case, the appropriate signature will be that of the person who can legally bind the infant.

This position would also apply with respect to making an election under subsection 39(4). However, an election under subsection 39(4) can be made only with respect to dispositions of "Canadian securities". Canadian security is defined in subsection 39(6) and means "... a security (other than a prescribed security) ...." Regulation 6200 deals with prescribed securities. Pursuant to subparagraph 6200(c)(iii), for the purposes of subsection 39(6) of the Act, a prescribed security includes, with respect to the taxpayer referred to in subsection 39(4) of the Act, a security that is a share that was acquired by that taxpayer in a transaction in which that taxpayer was not dealing at arm's length. Thus, if a child acquires shares from a non-arm's length person (e.g., a grandparent) such shares would be considered prescribed securities and the subsection 39(4) election would not be available to the child.

With respect to the capital gains and losses realized upon the disposition of the properties transferred to a minor child or a trust where the minor is beneficially interested, paragraph 19 of IT-Bulletin 510 state the following:

19. Where the property is transferred to a related minor or to a trust where a related minor is beneficially interested, subsection 74.1(2) does not apply to attribute to the transferor any taxable capital gain or allowable capital loss arising from a subsequent disposition of that transferred property by the minor or the trust...

Issue 2:

As for the second issue, the situation as we understand it is as follows:

A grandparent borrows funds to purchase Canadian listed securities. Later, that grandparent transfers the said securities to a minor grandchild. According to the attribution rules, the interest and dividend income will taxable in the hands of the transferor. However, the capital gains and losses will be taxable in the hands of the grandchild. Therefore, the question is whether or not the interest cost would still be deductible in the hands of the grandparent even if the properties are in the hands of the grandchild ?

Generally, when a taxpayer has disposed of property acquired with borrowed funds, the deduction for interest on those borrowed funds pursuant to paragraph 20(1)(c) of the Act is no longer available. To be eligible for a deduction under paragraph 20(1)(c), the borrowed money must continue to be used for the purpose of earning income from the property. When the property is disposed of and not replaced with another income earning property (unless section 20.1 applies) the use test in paragraph 20(1)(c) is no longer met. Under subsection 20.1(1) of the Act, when a property is disposed of for consideration which is not less than the fair market value of the property, the excess of the amount of the borrowed money over the fair market value of the property at the time of disposition will be deemed to be used for the purpose of earning income and, consequently, the interest expense on that excess amount will continue to be deductible pursuant to paragraph 20(1)(c) of the Act.

The Department of Finance Technical Notes, with respect to subsection 20.1(1), provide the following example involving a transfer of property to a child:

"A taxpayer borrowed $1,000 in 1992 to acquire shares of Corporation A at a cost of $1,600. The shares are such that the borrowed money is considered to be used for the purpose of earning income from property. The shares subsequently decline in value, and are sold by the taxpayer in 1994 for $900 (which is their fair market value). The taxpayer then invests the $900 in income-producing shares of Corporation B. None of the restrictions in the Act on the deduction of interest is applicable.

Same facts as above, except that instead of selling the shares of Corporation A, the taxpayer gives them to a child of the taxpayer.

Result:

1. To determine the amount of the borrowed money to which subsection 20.1(1) applies, it is necessary to determine how much of the borrowed money would be traceable to the proceeds if the taxpayer sold the shares for their fair market value. As in example 1, $563 would be so traceable. Thus, subsection 20.1(1) deems the remaining $437 of the borrowed money to continue to be used for the purpose of earning income from the shares of Corporation A, with the result that interest on this amount is still deductible.

2. Interest on the $563 is not deductible, since that amount is traceable to the shares that were given away."

In your particular situation, as in the example in the Technical Notes stated above (and on the assumption that the grand parent receives no consideration on the transfer), the interest deduction would not be available to the grandparent following the disposition of the shares to the child unless the fair market value of the shares at the time of transfer is less than the outstanding amount of the borrowed money at that time.

If the shares have declined in value to an amount less than the outstanding amount of the borrowed money, subsection 20.1(1) may apply to allow a continuing deduction for part of the interest on the borrowed money.

We hope that we have answered your questions and trust that our comments will be of assistance to you.

for Director
Financial Industries Division
Income Tax Rulings Directorate
Policy & Legislation Branch