LANGIND E
DOCNUM 2009-0352171E5
REFDATE 100421
SUBJECT Interest deductibility
SECTION 20(1)(c)
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:
Is mortgage interest deductible pursuant to
paragraph 20(1)(c) of the Act in a restructured borrowing arrangement ?
POSITION:
Appears so.
REASONS:
Direct use of borrowed money for income producing purpose
can be identified. The arrangement is very similar to the one proposed by
Hershfield J. in Sherle v The Queen.
XXXXXXXXXX
V. Srikanth
2009-035217
April 21, 2010
Dear XXXXXXXXXX :
Re: Interest deductibility
This is in response to your letter dated December 17, 2009, wherein you
requested our views regarding the interest deductibility on a particular
loan restructuring arrangement.
Specifically, you have described a situation wherein an individual
proposes to sell his primary residence to his parents at fair market
value. He receives a promissory note ("PN") as consideration. The
individual then plans to buy back the house from his parents, to use as a
rental property, by taking a mortgage on the property. The parents use the
proceeds to pay off the PN. The individual then uses the re-acquired
property for rental purposes and plans to buy a new property for his
principal residence.
You would like us to comment whether the interest paid on the mortgage
will be eligible for deduction pursuant to paragraph 20(1)(c) of the
Income Tax Act (the "Act"). We had conveyed our views to you over the
telephone on March 2, 2010. You, however, requested that we send you a
written response.
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. Your request was not submitted as an advance income tax ruling
request. 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 are not binding on CRA, and we are, accordingly, prepared to
provide you with the following comments.
Subparagraph 20(1)(c)(i) permits the deduction of an amount paid in the
year or payable in respect of the year, pursuant to a legal obligation to
pay interest on borrowed money used for the purpose of earning income from
a business or property. In general, the test to be applied for the use of
borrowed money is the direct use of the borrowed money and it must be done
giving effect to the legal relationships.
Interpretation Bulletin IT-533, entitled Interest Deductibility and
Related Issues, discusses the CRA's interpretations of the deductibility
of interest expense under various provisions of the Act and the judgments
in numerous court decisions involving the deductibility of interest
expense. The courts have determined that it is the direct use to which the
borrowed money is applied which governs whether the interest is deductible
for tax purposes. However, as indicated in paragraph 13 of IT-533, under
certain circumstances, the courts have stated that indirect use will be
accepted as an exception to the direct use test. In determining what
borrowed money has been used for, the onus is on the taxpayers to trace or
link the borrowed money to a specific eligible use, giving effect to the
existing legal relationships.
Further, paragraph 15 of IT-533 states that a taxpayer may restructure
borrowings and the ownership of assets to meet the direct use test. The
situation described above is very similar to the one described by
Hershfield J. in Sherle v The Queen, 2009 TCC 377 ("Sherle"). When
analyzing the borrowing arrangement on a home that the appellant co-owned
with her husband and converted from their principal residence to a rental
property, Hershfield J. made the following comments, explaining how the
appellant could have possibly arranged her affairs in order for interest
to be deductible on the borrowed funds:
"Indeed, the Appellant argued, without particular knowledge of the plan in
Singleton [Singleton v The Queen, (2001) 2 S.C.R. 1046], that she could
have sold the residence to a friend and bought it back and achieved the
desired result. For example, with the necessary legal advice, the
Appellant might have done something along the following lines:
*
On day 1 she sells her residence, the Joyce Property, to her
friend Ms. A. The purchase price is paid by issuing a Promissory Note;
*
On day 2 she takes a bank loan to discharge the mortgage on the
Ewart Property (the first loan). While the loan might only be a daylightbookkeeping entry, there is adequate security for it given that a
collateral charge will be immediately available on the Ewart Property upon
the payout of the former charge against it;
*
Also on day 2, she buys back the Joyce Property (her new rental
property), and finances this acquisition by borrowing money from the bank,
which loan is secured by a mortgage on the re-acquired property (the
second loan);
*
The proceeds of the latter mortgage are paid to her friend Ms. A
as consideration for this buy-back and Ms. A uses the proceeds to pay off
the Promissory Note she issued on the purchase of the property the day
before;
*
The proceeds from the Promissory Note are used by the Appellant to
pay off the first bank loan;
*
The only remaining loan is the second loan taken to acquire a
rental property;
*
Everything is done at fair market value without tax consequence,
and actual transfers of land need never be registered.
Since in this hypothetical scenario the direct use of the borrowed funds
would be to buy the rental property, applying the Singleton test of direct
use would most likely result in the interest on such borrowing being
deductible."
The restructuring described in your submission appears to be very similar
to the one described by Hershfield J. in Sherle and one which the court
considered would likely be acceptable for the purpose of interest
deductibility pursuant to paragraph 20(1)(c) of the Act. Hence, in our
view, after the restructuring described in the scenario in your
submission, the direct use test appears to be met such that the individual
should be eligible to claim an interest 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