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TAXFlash News from IncomeTaxCanada.net
:: Tax-deductible interest based on income-yielding investments as defined by the CCRA
:: In my last article I reviewed the ever-changing landscape in the world of tax-deductible interest touching briefly on CCRA’s recently released discussion paper promising “to use a practical approach”. This week, I’ll review several common situations where interest deductibility is an issue and provide CCRA’s interpretation in each case. Many taxpayers borrow to acquire income-yielding investments. The reference to “income” in this case envisions investments designed to provide a return to the investor in the form of interest or dividends. Relying on the “tracing principle” outlined in the Ludco case discussed in my previous article, the question CCRA will ask in these situations will be, “after considering all of 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)”? Notice the operative word here is “income” rather than the former standard of “profit”. This is more than semantics since the income test is easier to meet than the profit test. In its discussion paper CCRA goes on to note “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”. Reading between the lines here, I’d surmise that this means CCRA will be expecting the earning of income to be a significant part of the investment purpose. Nonetheless, in general, where income-yielding investments are purchased with borrowed funds, I don’t expect taxpayers will have much difficulty supporting an income tax deduction for the interest they pay. Where borrowing is undertaken to purchase common shares the primary issue is whether the objective of borrowing is to earn income. In many cases, it is reasonable for investors to expect that common shares will generate dividend income and this fact should be sufficient to satisfy the income-earning test. But what about situations where common shares don’t pay dividends? CCRA states “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”. In plain English, CCRA will seek to deny a deduction for interest expense if borrowed funds are used to purchase common shares where the only possible return to the investor is capital appreciation. On the other hand, “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”. This being the most common situation, interest expense incurred should be deductible for income tax purposes in the majority of cases where borrowing to purchase common shares is concerned. Often there is a need for shareholders of private companies to contribute capital to the company. Typically this happens when a company has reached its borrowing limit and the shareholders are asked to buck up. This is usually accomplished by having the shareholder(s) inject cash in the form of a shareholder loan – usually of the interest-free variety. The issue of tax-deductible interest arises when the shareholder(s) use borrowed funds for part or all of their shareholder contribution. In its discussion paper CCRA states “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”. Needless to say, this is a big issue for most shareholders of privately held corporations. CCRA does go on to say “a deduction may be available under the exceptional circumstances. 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”.
Generally, where wholly-owned companies are concerned this is the same as the existing policy, however, this is not the case where multiple shareholders are involved. Consider a situation where a company, with two equal shareholders, is in need of $10,000 of cash for operating purposes. What happens when one shareholder has the capacity to borrow but the second shareholder does not? Is the shareholder who takes out a $10,000 personal bank loan to inject cash into the company only permitted to deduct interest paid on one-half of his loan (i.e., $5,000 in this example) or is he denied an interest deduction altogether? Either way, the end result is inherently unfair for the shareholder who steps up to the plate and borrows to provide an interest free loan to his company. I don’t see the purpose served by this restriction other than to compound the considerable record-keeping already faced by small business owners. Furthermore, working around this issue is fairly simple – where multiple shareholders are involved, have each shareholder hold their operating company shares through a holding company. This solves the problem but at what cost? This particular draft policy seems ill-conceived and I don’t expect this CCRA policy to survive the transition from the discussion paper stage to an Interpretation Bulletin – at least I hope not.
Free Tax Advice Article Submitted to Income Tax Canada.net exclusively by Jim Maroney Official details about this and other topics on income taxes can be found in English & Francais at www.ccra-adrc.gc.ca Income tax information offered by www.IncomeTaxCanada.net is done so without endorsement by Canada Revenue Agency (CRA) - l'Agence du Revenu du Canada (ARC) (formerly Canada Customs and Revenue Agency - l'Agence des Douanes et du Revenu du Canada CCRA-ADRC and formerly Revenue Canada – Revenu du Canada) or any Canadian government agency. The free advice is of a general nature for Canadian taxpayers seeking legal ways to reduce their personal and small business income taxes payable to the federal and provincial (or territorial) governments in Alberta, British Columbia, Manitoba, New Brunswick Newfoundland-Labrador, Northwest Territories, Nova Scotia, Nunavut, Ontario, Prince Edward Island, Quebec, Saskatchewan or Yukon. Specific taxation situations vary from taxpayer to taxpayer, province to province, territory to territory. The free tax advice here is only a general guide. Canadians should always seek individual guidance on accounting rules and tax laws from knowledgeable accountants and lawyers. To prepare your income tax return online and NetFile your Canadian income taxes electronically in English or Francais, please visit www.ufile.ca or www.impotexpert.ca websites. Additional information on financial products and services for Canadians can be found at www.CanadianCreditCenter.com. |
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Jim Maroney