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.
Principal Issues: Where part of a loan is repaid using a portion of the property which was acquired with the loan (where the fmv of the acquired property has decreased), is interest expense deductible on the remaining portion of the loan?
Position: Yes
Reasons: Interest on the portion of the borrowed money that can be traced to the existing property is deductible pursuant to subparagraph 20(1)(c)(i) of the Act as a result of direct use test, and the portion of the borrowed money that has been lost because of a decline in value of the property, is deemed to continue to be used for the purpose of earning income from the property, pursuant to subsection 20.1(1) of the Act, and, therefore, deductible pursuant to subparagraph 20(1)(c)(i).
XXXXXXXXXX 2009-033510
V. Srikanth
August 27, 2010
Dear XXXXXXXXXX :
Re: Interest deductibility
This is in response to your letter dated July 28, 2009, wherein you requested our technical interpretation with respect to interest deductibility pursuant to paragraph 20(1)(c) of the Income Tax Act (the "Act").
The scenario you are concerned with is as follows:
An individual has borrowed $1.0 million from a financial institution and an additional $0.5 million from his wholly-owned corporation (the "Corporation"). The individual then invests the entire $1.5 million in a portfolio of various financial instruments for the purpose of earning property income. The individual has been deducting interest on the borrowed money under subparagraph 20(1)(c)(i) of the Act. There is a substantial decrease in the value of the investments in the portfolio since the time they were acquired. He subsequently transfers some of these investments to the Corporation in order to repay the loan of $0.5 million from the Corporation. He is now left with a loan of $1 million from the financial institution and the balance of the investments with a fair market value less than $1 million.
In your view, the individual should be eligible to claim an interest expense deduction on the remaining outstanding loan of $1 million and you seek our views.
Our Comments
Written confirmation of the tax implications inherent in actual proposed transactions is given by this Directorate only where the transactions are the subject of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R5, entitled Advance Income Tax Rulings. This Information Circular and other Canada Revenue Agency ("CRA") publications can be accessed on our website at http://www.cra-arc.gc.ca. If, however, the particular transactions are completed or partially completed, the enquiry should be addressed to the relevant Tax Services Office. However, as stated in paragraph 22 of IC 70-6R5, we do provide written opinions on general enquiries which are not advance income tax rulings and we are prepared to provide you with the following comments.
The following statements are from the Department of Finance 1994 Technical Notes that were issued when section 20.1 was introduced:
"Interest on borrowed money is deductible pursuant to paragraph 20(1)(c) of the Act, (subject to restrictions in some situations), where the borrowed money is used for the purpose of earning income from a business or property. As the courts have confirmed, interest ceases to be deductible under paragraph 20(1)(c) when the source of income to which the interest relates no longer exists and the borrowed money cannot be traced to another income-producing source.
New section 20.1 contains rules that apply where, because of a loss of source of income, borrowed money ceases to be used for an income-earning process. The rules ensure that interest on such borrowed money will, in certain circumstances, continue to be deductible under paragraph 20(1)(c). Section 20.1 is also applicable with respect to amounts payable for property acquired for an income-earning purpose....
New subsection 20.1(1) applies where a taxpayer who has used borrowed money for the purpose of earning income from a capital property, other than real property or depreciable property, ceases to use the money for that purpose after 1993 and a portion of the borrowed money has been lost because of a decline in value of the property. The portion of the borrowed money that has been lost is deemed to continue to be used for the purpose of earning income from the property. Consequently, that portion of the borrowed money will satisfy the use test in subparagraph 20(1)(c)(i) of the Act, and the property will continue to be considered a source of income of the taxpayer even though the taxpayer may have disposed of it. Thus, the taxpayer will be able to deduct interest on the portion of the borrowed money that has been lost (assuming none of the rules in the Act restricting the deduction of interest is applicable).
Generally, borrowed money will cease to be used for the purpose of earning income from a property when the taxpayer sells or otherwise disposes of the property....
Where a taxpayer has borrowed money under more than one debt obligation for the purpose of acquiring a property, subsection 20.1(1) applies with respect to the total amount of borrowed money that was being used to earn income from the property...."
Pursuant to paragraph 20.1(1)(a), the loss of source rules apply to an amount of borrowed money that ceases to be used for the purpose of earning income. The amount of borrowed money to which subsection 20.1(1) applies is then determined under paragraph 20.1(1)(b) as the amount of borrowed money outstanding immediately before the amount ceases to be used to earn income from the property less the following amounts:
(b)(i) where the taxpayer has disposed of the property for consideration at least equal to the fair market value ("fmv") of the property, the amount of the borrowed money used to acquire, or that is traceable to, the consideration,
(b)(ii) where the taxpayer has disposed of the property for consideration that is less than the fmv of the property, the amount of the borrowed money that would have been traceable to the fmv of the property, had the disposition taken place at fmv, less any reduction in the amount of borrowed money referred to in (iii),
(b)(iii) where the taxpayer has disposed of the property for consideration that includes a reduction in the amount of borrowed money, the amount of the reduction, and
(b)(iv) where the taxpayer has not disposed of the property, an amount equal to the fmv of the property that the taxpayer would have received if the taxpayer had disposed of the property.
The following examples have been provided to assist you in determining the total amount of borrowing considered to be used for income producing purposes under paragraph 20(1)(c) either directly or by virtue of subsection 20.1(1) of the Act:
Scenario 1:
A taxpayer borrows $3,000 and invests the entire amount in shares of various companies in the following amounts: Aco - $1,000, Bco - $1,000, and Cco - $1,000. At this point, interest on the entire $3,000 loan is deductible under subparagraph 20(1)(c)(i). On a later date, part of the property previously acquired with the borrowed money ceases to be used for income earning purposes, due to the fact that one of the companies, Cco, ceases to operate. As a result, at this later date, the fmv of Cco shares is nil. Further, assume that the fmv of the shares of the other companies is now: Aco - $1,000 and Bco - $500.
Since the taxpayer still holds the shares of Aco and Bco which it had acquired with $2,000 of borrowed money, $2,000 of the outstanding loan will continue to be considered to be used for income earning purposes under subparagraph 20(1)(c)(i) as a result of the direct use test. In order for interest on any portion of the remaining $1,000 of the loan to be deductible, the application of subsection 20.1(1) needs to be considered.
Under subsection 20.1(1), the amount that is deemed to continue to be used for the purpose of earning income is calculated as follows:
Amount of borrowed money immediately before it ceased to
be used for the purpose of earning income, i.e., the amount
of borrowed money used to acquire the Cco shares.
(paragraph 20.1(1)(b)) $1,000
Exceeds
Amount of borrowed money traceable to the proceeds
(equal to the fmv of the share - subparagraph 20.1(1)(b)(i)) n/a
Amount of borrowed money disposed of for less than fmv n/a
(subparagraph 20.1(1)(b)(ii))
Amount of reduction in the borrowed money n/a
(subparagraph 20.1(1)(b)(iii))
Amount of borrowed money equal to the fmv of the property
that is not disposed (subparagraph 20.1(1)(b)(iv)) $0 --------
Amount of borrowed money deemed to be used for $0
income-earning purposes under subsection 20.1(1) -------- $1,000
=====
Accordingly, the total amount of the loan considered to be used for income-earning purposes is calculated as follows:
Amount of borrowed money used for income-earning purposes
as a result of direct use test (subparagraph 20(1)(c)(i)) $2,000
Amount of borrowed money deemed to be
used for income-earning purposes under subsection 20.1(1) $1,000
Total amount of borrowed money considered to be used for --------
income-earning purposes (for purposes of paragraph 20(1)(c)) $3,000
=====
In this scenario, although a part of the property has ceased to be used for income earning purposes, subsection 20.1(1) deems it to be used for income-earning purposes such that interest on the total amount of the loan remains deductible.
Scenario 2
A taxpayer borrows $3,000 and invests the entire amount in the shares of a company. Again, at this point, interest on the $3,000 loan is deductible under subparagraph 20(1)(c)(i). The taxpayer, on a later date, disposes of all the shares at the fmv of $1,500. The proceeds from the sale are not reinvested and since the taxpayer no longer holds any shares, the direct use test is no longer met.
The amount that is deemed to continue to be used for the purpose of earning income is calculated as follows:
Amount of borrowed money immediately before it ceased to
be used for the purpose of earning income (paragraph 20.1(1)(b)) $3,000
Exceeds
Amount of borrowed money traceable to the proceeds
(equal to the fmv of the shares - subparagraph 20.1(1)(b)(i)) $1,500
---------Amount of borrowed money deemed to be
used for income-earning purposes (subsection 20.1(1)) $1,500
=====
In this scenario, although all the property has been disposed of, $1,500 of the outstanding loan is deemed to be used for income earning purposes as a result of the application of subsection 20.1(1) of the Act.
Scenario 3:
Finally, consider a situation where a taxpayer obtains two different loans, one for $2,000 and another for $1,000, and invests the entire amount in shares of a corporation. (According to the Finance Technical Notes, the two loans are to be considered together.) Interest on the $3,000 loan is deductible under subparagraph 20(1)(c)(i). Subsequently, the value of the shares decreases to $1,500. The taxpayer then disposes of part of his portfolio with a fmv of $1,000 (and a cost of $2,000) and settles the $1,000 loan. The taxpayer is now left with a loan of $2,000, and assets having a fmv of $500 and a cost of $1,000.
Since the taxpayer still holds shares that it had acquired with $1,000 of borrowed money, $1,000 of the outstanding loan of $2,000 will continue to be considered to be used for income earning purposes as a result of the direct use test. In order for interest on any of the remaining $1,000 of the loan to be deductible, the application of subsection 20.1(1) needs to be considered.
The amount that is deemed to continue to be used for the purpose of earning income is calculated as follows:
Amount of borrowed money immediately before it ceased to
be used for the purpose of earning income, i.e., the amount
of borrowed money used to acquire the shares now disposed of
(paragraph 20.1(1)(b)) $2,000
Exceeds
Amount of borrowed money traceable to the proceeds
(subparagraph 20.1(1)(b)(i)) $1,000
---------
Amount of borrowed money deemed to be
used for income-earning purposes under subsection 20.1(1) $1,000
=====Accordingly, the total amount of the loan considered to be used for income-earning purposes is calculated as follows:
Amount of borrowed money used for income-earning purposes
as a result of direct use test (subparagraph 20(1)(c)(i)) $1,000
Amount of borrowed money deemed to be
used for income-earning purposes under subsection 20.1(1) $1,000
Total amount of borrowed money considered to be used for --------
income-earning purposes $2,000 =====
In this scenario, the outstanding loan is considered to be used for income producing purposes under subparagraph 20(1)(c)(i) partly because of direct use test and partly because of subsection 20.1(1).
In the scenario you provided, the individual acquired property with $1.5 million of borrowed money from two different sources, however, as noted above, the two loans are to be considered together. We assume the interest thereon was deductible. You have mentioned that the fmv of the property has declined considerably. In order to analyze this scenario, we are assuming that the fmv of the property has fallen to $1 million. The individual subsequently transfers some of these investments, with a fmv of $0.5 million and a cost of $0.75 million, to the Corporation in order to repay the $0.5 million loan from the Corporation. The individual is left with a loan of $1 million and property with a fmv of $0.5 million and a cost of $0.75 million. This scenario is similar to Scenario 3 above.
The amount of the loan that is considered to continue to be used for the purpose of earning income is calculated as follows:
Since the taxpayer still holds shares which it had acquired with $0.75 million of borrowed money, $0.75 million of the outstanding loan will be considered to be used for income earning purposes as a result of the direct use test. In order for the interest on any of the remaining $0.25 million of the loan to be deductible, the application of subsection 20.1(1) needs to be considered.
The amount that is deemed to continue to be used for the purpose of earning income under subsection 20.1(1) is calculated as follows:
Amount of borrowed money immediately before it ceased to
be used for the purpose of earning income, i.e., the amount
of borrowed money used to acquire the shares now disposed of
(paragraph 20.1(1)(b)) $0.75MExceeds
Amount of reduction in the borrowed money
(subparagraph 20.1(1)(b)(iii))* $0.50M
---------
Amount of borrowed money deemed to be
used for income-earning purposes under subsection 20.1(1) $0.25M
======
* When a taxpayer disposes of the property to the creditor in return for a reduction in the amount owed, subparagraph 20.1(1)(b)(i) would not apply with respect to the reduction, since the reduction would not be a consideration to which the borrowed money is traceable. However, subparagraph 20.1(1)(b)(iii) would be applicable.
Accordingly, the total amount of the remaining $1 million loan considered to be used for income-earning purposes is calculated as follows:
Amount of borrowed money used for income-earning purposes
as a result of direct use test (subparagraph 20(1)(c)(i)) $0.75M
Amount of borrowed money deemed to be
used for income-earning purposes under subsection 20.1(1) $0.25M
Total amount of borrowed money considered to be used for --------
income-earning purposes under subparagraph 20(1)(c)(i) $1.00M
=====Based on this analysis, we agree with your view that, in the general scenario provided, where an individual has disposed of part of the property, whose fmv has decreased significantly, and where the proceeds are used to settle part of the loan, the interest on which was previously deductible, the individual should be eligible to deduct interest on the remaining loan. Accordingly, in the scenario you provided, on the assumption that the interest on the borrowings was previously deductible, in our view, interest on the outstanding loan of $1 million will be eligible for deduction pursuant to subparagraph 20(1)(c)(i) of the Act.
We trust our comments will be of assistance to you.
Yours truly,
R.A. Albert, CA
For Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch
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