Interest Deductibility & Related Issues

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1 Interest Deductibility & Related Issues

2 Agenda Introduction Basic Principles Provide an Overview of Legislation & Case Law CRA Administration Practice Eligible Indirect Uses of Borrowed Money Purpose of Earning Income Other Matters

3 Who is interested in Interest Deductibility? Canada Revenue Agency Anxious to oppose any deductions Taxpayer Goal is to minimize taxes

4 Mortgage Interest Tax Deductibility US residence vs. Canadian residence Singleton Case Lawyer withdrew $300,000 from his capital account Funds used to purchase a home registered in spouse s name Later that day borrowed similar amount to pay back capital account Interest on loan claimed as a tax deduction Supreme Court of Canada allowed deduction borrowed funds used for an eligible purpose

5 Mortgage Interest Tax Deductibility Lipson Case Supreme Court of Canada April 23, 2008 Facts: Two spouses entered into an agreement to purchase a personal residence Mrs. Obtained demand loan to purchase shares of a family company from Mr. Mr. used the funds from share sale to purchase the personal residence Permanent financing was obtained (secured against the house) to repay the demand loan Interest on loan not deductible due to GAAR!

6 Basic Principles Income from a business or property Income earned from an office or employment and from a business or a property is taxable Subject to Part I tax, the profit from that business or property for the year Tax rules may restrict the ability to claim certain deductions No deduction for capital payments except as otherwise permitted by Part I.

7 Essential Characteristics of Interest Interest is not defined in the Act: Several court decisions have defined interest for tax purposes Shell, Sherway Centre and Miller Paragraph 20(1)(c) of the Act lays out four requirements for interest on borrowed money to be deductible: Amount must be paid in the year or be payable in the year Amount must be paid pursuant to a legal obligation to pay interest on borrowed money Loaned money must be used for the purpose of earning non-exempt income from a business or property Amount must be reasonable

8 Interest Deductibility The conditions to be met for interest to be deductible are specifically related to the purpose of the borrowed money such as: i. to earn income from a business or property; ii. to acquire a property for the purpose of gaining and producing taxable income from the property or from a business; iii. to acquire an interest in a certain type of annuity contract in respect of which an amount is included in computing the taxpayer s income for the taxation year

9 Interest Deductibility - Elements of 20(1)(c) Requirements for interest on borrowed money to be deductible: (1) Amount must be paid in the year or be payable in respect of the year (2) Amount must be paid or payable pursuant to a legal obligation to pay interest on borrowed money, and (3) Interest must be payable on borrowed money used for the purpose of earning income from a business or property other than exempt income or to acquire a life inusrance policy, (4) Amount must be reasonable

10 1. An amount paid in the year or payable in respect of the year Paid: Applicable only to cash method computation of income (M.N.R v. Mid- West Abrasive) Does not apply to persons computing income on an accrual basis Payable: Only if income computed on accrual basis (everyone except cash basis taxpayers) in respect of the year = the year in which the borrowed funds were used (Mid-West Abrasive case (783 DTC 5429 (FCTD))

11 2...pursuant to a legal obligation to pay interest.. Current legal obligation to pay interest: Loan agreement must include obligation to pay interest Payment cannot be contingent on future events (Barbican Properties)

12 2...pursuant to a legal obligation to pay interest.. Barbican Properties v. The Queen, 97 DTC 5008 (FCA) Borrower s option to defer interest payments if profit threshold not met Limited recourse of lender against borrower from the sale of the properties Payable effectively equated to enforceable right to payment on the part of the lender

13 3. Loaned money must be used for the purpose of earning non-exempt income from a business or property Purpose and income Ludco Enterprises Ltd DTC 5505 (SCC) Shell, Singleton, Penn Ventilator and Canadian Helicopters CRA generally denied interest expense on the basis that: Not used directly in business Amount unreasonable Courts allowed deductions where: Direct use (ancillary use acceptable) Direct link Exceptional circumstances

14 4. Amount must be reasonable Deduction for interest is the lesser of the actual amount and a reasonable amount Reasonability of interest rate: consideration will be given to prevailing market rates for debts with similar terms and credit risks, and the existence of any issue premiums Presumption that rate is reasonable with arm s length parties.

15 CRA s Administrative Policy IT-533 Response from CRA as a result of recent cases won by the taxpayer IT-533 Interest Deductibility and Related Issues General principles Look at direct use (or current use, if different) of money is there an income-earning purpose associated with that use Exceptional circumstances will permit deductibility in other situations Onus is on taxpayer to trace the funds to an identifiable eligible use Restructuring borrowings Cash damming Commingled source Disappearing source Amalgamation/Wind-up

16 Eligible Indirect Used of Borrowed Money Money borrowed to redeem shares, return capital or pay dividends Money borrowed by a partnership to return capital to a partner Money borrowed to make interest-free loans and contributions of capital Money borrowed to make interest-free loans to employees and shareholders

17 Purpose of Earning Income Money borrowed to acquire common shares Money borrowed to acquire income-yielding investments Borrowing for loss utilization purposes

18 Other Matters Proposed Section 3.1 Legislated reasonable expectation of profit test (REOP) Proposed subsection 3.1(1) A taxpayer has a loss for a taxation year from a source that is a business or property only if, in the year, it is reasonable to expect that the taxpayer will realize a cumulative profit from that business or property for the period in which the taxpayer has carried on, and can reasonably be expected to carry on, that business or has held, and can reasonably be expected to hold, that property. Proposed subsection 3.1(2) states that profit is determined without reference to capital gains or losses Effective for taxation years that begin after 2004

19 RRSP Issues Contributions in kind Permissible as long as an eligible investment RRSP swaps

20 RRSP Swaps The removal and substitution from RRSP No withdrawal from, no contribution to the RRSP Value of substituted investments is equal to value of removed investments Personal tax implications Capital gain on assets transferred with accrued gains Capital loss may be denied added to cost base of asset Superficial loss rules

21 Conclusion Interest deductibility continues to be an area of uncertainty and concern and new developments should be monitored closely Caution for RRSP swaps Know your client and advise them to get appropriate tax advice

22 Questions

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