Tax Strategy
In the Interest of Deductions
In certain circumstances, taxpayers can deduct interest
payments on borrowed funds as business expenses.
FROM: MAY-JUN 2004 ISSUE | BY DAVID NOLKE
When the courts rule against the Minister of National Revenue, often the Finance Department changes the law. Last year was no exception. The 2003 Federal Budget included proposed changes to the Income Tax Act, aimed at clarifying when interest can be deducted as an expense.
One of the most notable court cases concerning interest deductibility is the Ludco case [Ludco Enterprises Ltd., Brian Ludmer,David Ludmer, and Cindy Ludmer (appellants) v. the Queen (respondent) 2001 DTC 5518] . Ludco deducted $6 million in interest on funds borrowed to buy shares in foreign corporations. The company received $600,000 in dividend income and later sold the shares, realizing a capital gain of $9.2 million. The Canada Revenue Agency disallowed the interest deduction. After losing its appeal at the Tax Court of Canada, at the Federal Court Trial Division, and at the Federal Court of Appeal, Ludco requested leave to appeal to the Supreme Court of Canada.
The Supreme Court allowed Ludco's appeal, indicating that the interest costs were deductible under subparagraph 20(1)(c)(i) of the Income Tax Act.
Subparagraph 20(1)(c)(i) requires that borrowed money must be used for the purpose of earning income from a business or property. When interpreting the word "used," the Courts have considered whether it means "first used" or "currently used." Several cases, most at the Supreme Court level, have decided that "used" refers to the current use of the borrowed funds.
Taxpayers must prove a link between the borrowed money and its current use. For example, if the taxpayer borrowed the funds to purchase a personal residence, the interest would generally not be deductible because the borrowed funds were not being "used" for the purpose of earning income from a business or property. If, however, there was a change in the use of the property, for example, the owner decided to rent it for profit, then the same borrowed funds would be directly linked to an income-producing property and the interest incurred during the current use of the property would be deductible against rental income.
However, if the owner increased the mortgage on the property at the time of the change in its use, but used the funds to pay down his or her personal mortgage, the interest on that portion of the borrowed funds would not be deductible since the taxpayer used the funds for personal purposes.
In the Ludco decision, the Court stated, "Although earning income was not the principal factor that motivated Ludco to invest in the foreign companies, [Ludco] anticipated the receipt of dividend income and the objective documentary evidence indicates that the appellants had a reasonable expectation of earning income. Furthermore, dividend income was actually received." In rendering its decision, the Supreme Court linked the use of the borrowed funds to both the dividend income and the capital gain that the taxpayer realized on the subsequent sale of the shares, stating that "income" refers to income subject to income tax and not net income.
As the Court states, Ludco had a reasonable expectation of earning income from its foreign investments. But did the company have a reasonable expectation of profit? The proposed changes to the Act set out to clarify this issue.
In a Notice of Ways and Means Motion to the 2003 Federal Budget, the Finance Department states, "Recent Court decisions have raised uncertainties as to how taxpayers treat expenses, in particular interest, in computing income from a business or property for purposes of the Income Tax Act. Most notably, these decisions could lead to inappropriate tax results where a taxpayer derives a tax loss by deducting interest expenses, even if under any objective standard there is no reasonable expectation that the taxpayer would earn any income (as opposed to capital gains) or where the presence or prospect of revenue (as opposed to income net of expenses) is enough to conclude that an expenditure was incurred 'for the purposes of earning income'." In other words, taxpayers must consider whether there is a reasonable expectation of profit from the use of the borrowed funds, measured as income less expenses.
The main proposed amendments to the Income Tax Act are contained in the new section 3.1, which creates a reasonable expectation of profit test. Proposed subsection 3.1(1) states that, "A taxpayer has a loss for a taxation year from a source that is 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, or can reasonably be expected to carry on, that business or has held or can reasonably be expected to hold that property." This test applies not only to interest, but also to virtually any expense that contributes to a loss. Proposed subsection 3.1(2) states, "For purposes of subsection (1), profit is determined without reference to capital gains or capital losses." The proposed amendments, subject to consultation, will take effect for the taxation years after 2004.
Interpretation Bulletin IT 533, issued October 31, 2003, provides a detailed discussion on interest deductibility, and refers to the proposed changes to interest deductibility tests.
Many years ago, the Supreme Court decided interest was not an expense, but rather, a capital payment and therefore not deductible according to paragraph 18(1)(a) of the Act, which allows a deduction for expenses incurred to earn income. To deduct interest, taxpayers must rely on paragraph 20(1)(c), which allows interest to be a deduction if the borrowed funds on which interest is paid are used to earn income from business or property. Proposed section 3.1 further restricts the deductibility of interest by imposing a "reasonable expectation of profit" test, and by excluding capital gains from the definition of profit.
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David Nolke, FCGA, is proprietor of Nolke & Co., Certified General Accountant, in Calgary, and president of Integrated Business Advisory Services Inc., providing tax and management counsel to industry, government and other professionals. E-mail dgn@shawbiz.ca.
"Tax Strategy" is co-ordinated by J. ThomasMcCallum, CBV, FCGA, a business valuation and income tax consultant based in Whitby, Ontario, and author of several CGA-Canada professional development courses. E-mail jtmc@jthomasmccallum.com.
The information appearing in "Tax Strategy" is provided for the interest of the readers. Neither CGA Magazine nor the column authors and co-ordinator assumes any responsibility or liability to any persons relying on the information in the article to perform tax planning and/or compliance of any kind.