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| Adrian Mastracci, president
of fee-only KCM Wealth Management, says "These
proposals affect a wide variety of taxpayers
such as individuals, trusts, estates, small
and large business." |
For Immediate Release
Vancouver, BC (October 15, 2002):
The Canada Customs and Revenue Agency (CCRA) lost
two legal cases in 2001, known as “Ludco”
and “Singleton”. Both cases involved
the deduction of interest on borrowed funds.
As a result, CCRA conducted a review of its interpretations
and administrative policy on interest deductibility.
It recently made public its perspectives by way
proposals. The CCRA position was the subject of
a presentation to the Canadian Tax Foundation
earlier this month.
Adrian Mastracci, president
& investment counsel at Vancouver’s
fee-only KCM Wealth Management
comments, “CCRA has outlined 18 proposals
which, if and when implemented, could change many
areas pertaining to the deductibility of interest
incurred on borrowed funds. These proposals affect
a wide variety of taxpayers such as individuals,
trusts, estates, small and large business. Virtually
everyone who may deduct interest on borrowed capital.”
“The discussion paper on the proposed CCRA
interpretations is worthy reading for all borrowers,”
notes Mastracci, “Being aware of the proposals
could be helpful in planning an investor's specific
situation.”
“It should be noted that the proposals
are not yet the CCRA accepted interpretation and
policy,” says Mastracci, “There will
likely be additional revisions on some of the
proposals before they become the new standard.”
“It is important to be aware of the potential
changes as they may affect a specific situation.
The time frame for implementation could well be
by early 2003. Hence, time is of the essence,”
recommends Mastracci.
“The proposals are important because they
affect practically all areas of interest deductibility,"
indicates Mastracci, "A key to all the proposals
is that the requirement that borrowers keep track
of the borrowed funds so that each loan can be
traced to a particular purpose is now relaxed.
The concept of linking the borrowed money came
out of the Supreme Court decisions.”
”Mutual fund investors will be interested
in proposal E: Borrowing to acquire common shares,”
points out Mastracci, "While corporate borrowers
may want to revisit borrowing to pay dividends
or shareholder loans."
“CCRA is inviting taxpayers and their advisors
to make comments and submissions on the proposals
until December 31, 2002. It may be valuable to
consult your advisors to review the proposals
vis-a-vis your specific situation,” suggests
Mastracci.
“The content of the presentation, which
I have reproduced below, is found on the CCRA
web site at http://www.ccra-adrc.gc.ca/tax/technical/incometax/presentation-e.shtml.
It may also be appropriate to check this site
from time to time for updated information,”
explains Mastracci, “Please note that references
to Section 20 are the interest deductibility paragraphs
of the Income Tax Act.”
Mastracci concludes, "If anyone has loans
outstanding, or is contemplating a loan, they
will be impacted in some fashion. It's best to
become informed of the potential changes on the
horizon."
Comments may be provided by December 31, 2002
to Mr. Paul Lynch, Director Financial Industries
Division, Income Tax Rulings Directorate either
by e-mail at paul.lynch@ccra-adrc.gc.ca, by fax
at (613)957-2088 or by mail at the following address:
16th floor, Place de Ville, Tower A, 320 Queen
Street, Ottawa, Ontario, K1A 0L5.
by Roy Shultis and Paul Lynch on October 1, 2002
Update on our review of interest deductibility
issues
On October 2, 2001, the CCRA announced that officials
in the Income Tax Rulings Directorate were reviewing
the CCRA's existing interpretive and administrative
positions on interest deductibility following
the Ludco and Singleton decisions rendered by
the Supreme Court of Canada on September 28, 2001.
As part of this process, we have consulted and
will continue to consult with the Departments
of Finance and Justice as well as several tax
associations.
We have set out our perspective on the preliminary
results of this review in this document. Following
the consultation period described below, we anticipate
that a new interpretation bulletin on interest
deductibility will be issued setting out CCRA's
official interpretations on interest deductibility
issues and the following interpretation bulletins
are expected to be cancelled at that time:
- IT-80, Interest on money borrowed to redeem
shares, or to pay dividends.
- IT-203, Interest on death duties.
- IT-315, Interest expense incurred for the
purpose of winding-up or amalgamation.
- IT-445, The deduction of interest on funds
borrowed either to be loaned at less than a
reasonable rate of interest or to honour a guarantee
given for inadequate consideration in non-arm's
length situations.
- IT-498, The deductibility of interest on money
borrowed to reloan to employees or shareholders.
In order to complete our review, taxpayers and
their advisors are invited to make submissions
on our preliminary results outlined in this document
(before the end of 2002). Submissions should be
directed to the attention of Paul Lynch, Director,
Financial Industries Division, Income Tax Rulings
Directorate, 16th floor, 320 Queen Street, Ottawa,
Ontario K1A 0L5 (facsimile number (613) 957-2088).
Proposed interpretations on the deduction of
interest
The key issues relating to interest deductibility
involve ascertaining the direct use (and current
use, if different) of borrowed money and identifying
an income-earning purpose associated with that
use. Beyond this level of analysis, we accept
the "exceptional circumstances" category
for deductibility of interest in other situations.
Tracing is fundamental to determining the use
of borrowed money for purposes of interest deductibility
under paragraph 20(1)(c). The Supreme Court of
Canada had stated that the onus is on the taxpayer
to trace funds to a current eligible use (Bronfman
Trust). When borrowed money is directly applied
to a given use, its use is readily determined.
However, given the fungible nature of money and
frequent commingling of borrowed money with money
that has not been borrowed, it is not possible
in many cases to trace money through to its various
uses. Recent decisions of the Supreme Court have
introduced the concept of linking borrowed money,
rather than tracing it, to its use, as well as
approving of a flexible approach to tracing/linking
(Tennant, Shell, Ludco). In this context, we will
use a practical approach to determining the use
of borrowed money and its redeployments. As a
reasonable proxy for tracing, if taxpayers can
demonstrate that the aggregate eligible expenditures
from a commingled cash account exceed the amount
of borrowed money deposited to that account, we
will generally accept that the taxpayer has satisfied
the test of tracing/linking borrowed money to
eligible uses.
Cash damming techniques serve to ensure that borrowed
monies are used for specific, and presumably,
eligible uses. We accept that this is consistent
with the wording of paragraph 20(1)(c) as well
as court decisions and serves to facilitate the
tracing/linking process.
Interest on accounts payable for service costs
that are currently deductible expenses is deductible
under section 9.
This issue relates to the purpose test in paragraph
20(1)(c) regarding the acquisition of a debt or
equity investment that has a stated interest or
dividend rate. The Supreme Court (Ludco) has indicated
that the purpose test 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).
We also recognize and accept the Court's remarks
that the use of borrowed money for an ancillary
purpose of earning income can meet the test for
interest deductibility (i.e. the main or overriding
purpose for the use of the borrowed money need
not necessarily be to earn income). However, the
finding of the purpose for the use of borrowed
money will be a question of fact and the facts
may indicate that the purpose of using borrowed
funds does not give rise to an interest deduction
(e.g. 722540 Ontario Inc., Novopharm Limited).
The primary issue with regard to this topic is
the income earning purpose of the share acquisition.
As stated above, the purpose test is 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).
Normally, we consider interest costs in respect
of funds borrowed to purchase common shares to
be deductible on the basis that there is a reasonable
expectation (at the time the shares are acquired)
that the common shareholder will receive dividends.
However, it is conceivable that in certain fact
situations, such reasonable expectation would
not be present.
Where evidence from corporate officials indicates
that dividends are not expected to be paid and
that shareholders are required to sell their shares
in order to realize their value, the purpose test
would likely not be met. Where a corporation is
silent with respect to its dividend policy, or
where the dividend policy is that dividends will
be paid when operational circumstances permit,
the purpose test will likely be met. However,
each situation must be dealt with on the basis
of the particular facts involved.
The foregoing comments are also generally applicable
to investments in mutual fund trusts and mutual
fund corporations.
Participating payments for amounts that are interest
are deductible under paragraph 20(1)(c) where
the payment is limited to a stated percentage
of the principal or the facts show that they are
intended to increase the interest rate on the
loan to the prevailing market rate, the limiting
percentage, if any, reflects prevailing arm's-length
commercial interest rates, and no other facts
indicate the presence of an equity investment.
It should be noted that participating payments
are not deductible under subparagraph 20(1)(e)(iv.1)
as an expense incurred in the course of borrowing
money.
Where an amount computed as interest is not payable
in a year because of an unsatisfied contingency,
the provisions of paragraph 20(1)(c) are not met
as the interest is not paid or payable, and the
interest is not deductible in that year. When
such amounts are paid in a subsequent year, the
interest for prior years would not be in respect
of the year as required by paragraph 20(1)(c)
and the interest would not be deductible when
paid (Mid-West Abrasive).
Where debts are issued with a stated interest
rate lower than prevailing market rates, i.e.
at a discount, the debt issuer will receive less
than 100% of the principal amount of the debt
issue. Two particular issues arise in these situations,
namely what is the amount of borrowed money for
purposes of paragraph 20(1)(c) and what amount,
if any, is deductible in recognition of the discount
when the principal amount of the debt is repaid.
Both situations are addressed in the Act. Subsection
20(2) provides that the principal amount of the
debt will generally be the amount of borrowed
money and paragraph 20(1)(f) provides for a full
or partial deduction of the discount at repayment
depending upon the extent of the discount.
For debts issued which have no interest stipulated
to be payable, taxpayers in a lending business
will generally be entitled to a deduction of the
discount under section 9 on the payment at maturity
of the debt. Other taxpayers will have neither
a deduction nor a capital loss since on maturity
of the debt there is no disposition of a property.
Where debts are issued with a stated interest
rate greater than prevailing market rates, i.e.
at a premium, the debt issuer will receive greater
than 100% off the principal amount of the debt
issue. The issue arising in this situation is
the tax treatment to the debt issuer for the receipt
of the premium amount. Where the issuer is in
the lending business, the premium amount will
be included in computing income under section
9. For other taxpayers, where the premium arises
solely because of market timing, it will generally
be considered a non-taxable capital receipt. Where
the premium arises because the debt was deliberately
priced to give rise to a premium, the amount received
by the issuer will again generally be considered
a non-taxable capital receipt. However, where
the pricing of the interest rate on a debt is
clearly in excess of commercial arm's-length rates,
the reasonableness of the interest rate would
be subject to challenge under paragraph 20(1)(c).
The Supreme Court has outlined that direct use
is the primary test to determine interest deductibility,
and that indirect uses will not be acceptable,
other than in exceptional circumstances. Trans-Prairie
Pipelines Ltd. is the leading case with regard
to exceptional circumstances and remains valid
today. This case addressed the exceptional circumstances
of borrowing to redeem shares. The concept of
using borrowed money to "fill the hole"
of capital withdrawn from the corporation's business
is a key element of this concept. We accept these
exceptional circumstances for interest deductibility
provided that the capital replaced by the borrowing
was previously used for an eligible purpose of
earning income from a business or property. We
further accept that borrowing to return capital
could also apply in a partnership context.
Based on the preceding analysis, the amount of
capital used for an eligible purpose of earning
income prior to the replacement of that capital
with borrowed money must be determined. We generally
accept that capital includes the contributed capital
and accumulated profits of a corporation or partnership.
Contributed capital is considered to be the funds
provided by the owners of a corporation or partnership
to commence or to further the carrying on of the
corporate or partnership business. We accept that
in most corporate situations the legal or stated
capital for corporate law purposes would be the
best measurement of capital for this purpose,
although other measurements may be more appropriate
depending upon the circumstances.
Generally, accumulated profits means retained
earnings computed on an unconsolidated basis with
investments accounted for on a cost basis. However,
profits or gains resulting from the disposition
of property to persons with whom the taxpayer
does not deal at arm's length will generally be
excluded.
The underlying concept remains that of "filling
the hole" of capital withdrawn from the business.
In situations where some proportion of shares
is being replaced with borrowed money, only the
capital of those shares, computed on a pro-rata
basis, would be considered to be replaced with
the borrowed money. The accumulated profits of
a corporation, however, do not track any particular
shareholdings.
Borrowing to pay dividends is an ineligible direct
use, but interest deductibility in such situations
may be provided under the exceptional circumstances
category, consistent with the concept of borrowing
to replace capital to "fill the hole"
described above. We generally accept this category
of exceptional circumstances and generally accepts
accumulated profits (as described in J above)
as the appropriate measurement of the hole that
may be filled with the borrowed money used to
pay a dividend.
Where a note is issued to redeem shares, interest
deductibility may be provided under the exceptional
circumstances category, in accordance with the
decision in Penn-Ventilator. Consistent with the
exceptional circumstances described in I above,
interest would be deductible to the extent of
the interest on the amount of the notes issued
within the limits for capital described in J above
for redeeming shares or paying dividends. Interest
on notes issued to pay dividends would not qualify
for deduction since no property is acquired in
such a transaction.
In such circumstances, the direct use of the borrowed
money is ineligible since no income can be generated
from the property acquired. Thus, interest on
borrowed money to acquire such property is generally
not deductible. However, in certain factual situations,
a deduction may be available under the exceptional
circumstances category. No comprehensive guidelines
can be provided as to when such a borrowing would
qualify. However, we would generally accept the
deduction of interest on borrowed money used to
make an interest-free loan to a wholly-owned corporation
(or in cases of multiple shareholders, where each
shareholder makes an interest-free loan in proportion
to their shareholdings) where the proceeds will
be used by the corporation to produce income,
thereby increasing the potential dividends to
be received. Interest deductibility in other situations
involving interest-free loans may also be warranted
depending upon the particular facts of a given
situation.
Where borrowed money is used to make a loan to
an employee or shareholder, the direct use is
the acquisition of a debt instrument from the
employee or shareholder. Where there is a reasonable
expectation of income from that debt instrument,
the interest on the borrowed money would be deductible
in accordance with D above. Where there is no
reasonable expectation of income from the debt
instrument, interest on borrowed money to make
such loans would not be deductible, subject to
any deduction available under the exceptional
circumstances category. No comprehensive guidelines
can be provided as to when such a borrowing would
qualify. Generally, interest on money borrowed
to make interest-free loans to individual shareholders
would not qualify. However, we would generally
accept the deduction of interest on borrowed money
used to make interest-free loans to employees
in their capacity as employees, as such loans
would be viewed as a form of remuneration for
the services of the employees. Interest deductibility
in other situations involving interest-free loans
to employees or shareholders may also be warranted
depending upon the particular facts of a given
situation (e.g. Canadian Helicopters).
Paragraph 20(1)(c) restricts the circumstances
where interest on borrowed money is deductible
to cases where borrowed money is used to earn
income from a business of the borrower or to acquire
an income producing property. Funds borrowed by
a shareholder which are used to contribute surplus
to a corporation are not used for either of these
purposes. Thus, interest on borrowed money for
such purposes is not deductible, subject to any
deduction available under the exceptional circumstances
category. No comprehensive guidelines can be provided
as to when such a borrowing would qualify. However,
we would generally accept the deduction of interest
on borrowed money used to make a contribution
of capital to a wholly-owned corporation (or in
cases of multiple shareholders, where each shareholder
makes a contribution of capital in proportion
to their shareholdings) where the proceeds will
be used by the corporation to produce income,
thereby increasing the potential dividends to
be received. Interest deductibility in other situations
involving contributions of capital may also be
warranted depending upon the particular facts
of a given situation.
In order to transfer losses within a group of
affiliated corporations, an arrangement is generally
structured such that the company in the loss position
lends money at interest to the profitable corporation,
which in turn invests in preferred shares of the
loss company. As is the case with borrowing to
acquire income-yielding investments described
in D above, it is our view that generally interest
paid on borrowed money to acquire an investment
that has a stated rate of income will be fully
deductible under paragraph 20(1)(c). Although
the dominant purpose for such a borrowing may
be to utilize losses, the ancillary purpose of
earning income would generally be sufficient to
justify interest deductibility (Ludco).
Where a taxpayer provides a guarantee for no consideration
in respect of a debt and is called upon to honour
the guarantee and does so with borrowed money,
the borrowed money is used for the purpose of
paying a debt of another person. Accordingly,
in such situations, the direct use of borrowed
money to honour a guarantee is generally not for
an income earning purpose and such interest would
not be deductible, subject to any deduction available
under the exceptional circumstances category.
No comprehensive guidelines can be provided as
to when such a borrowing would qualify. However,
we would generally accept the deduction of interest
on borrowed money used to honour the guarantee
of a loan of a wholly-owned corporation (or in
cases of multiple shareholders, where each shareholder
used borrowed money to honour the guarantee of
a loan of the corporation in proportion their
shareholdings) where the transaction serves to
increase the potential dividends to be received.
Where a taxpayer provides a guarantee in respect
of a debt for fair market value consideration,
this consideration represents a source of income
to the taxpayer with the result that interest
on money borrowed to honour the guarantee generally
will be deductible.
Interest deductibility in other situations involving
borrowing to honour a guarantee may also be warranted
depending upon the particular facts of a given
situation.
In a typical leveraged buy-out, borrowed money
is initially used to acquire common shares of
the target company and interest on that borrowed
money would generally be deductible pursuant to
our interpretation on common shares described
in E above. After acquisition of the target company,
the corporation holding its shares (and that has
borrowed money) is amalgamated with, or winds-up,
the target company.
In Ludco, the Supreme Court reinforced the current
use/tracing principle in Tennant and extended
it with reference to a flexible approach to establishing
a link. It is our view that this approach would
allow the establishment of a link for the current
use of the borrowed money between the shares that
were initially acquired and the assets formerly
held by the corporate target that are now owned
by the initial corporate borrower. There is no
arm's-length requirement in establishing such
a link.
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