|
FROM: NOV-DEC 2008 ISSUE | BY MANU KAKKAR
In my practice, I spend a lot of time looking over other accountants’ financial statements. For accounting purposes, interest expense is deducted in arriving at net income. For tax purposes, interest expense follows the accounting treatment in most cases and is deductible; however, from time to time I do encounter a series of transaction steps in which interest is not deductible as originally contemplated. In these circumstances, a new sequence of transaction steps needs to be devised to achieve the same business objective and make the interest deductible.
Based on the prevailing jurisprudence, interest has three components:
- Interest represents compensation for the use of money by the lender;
- Interest is referable (usually by percentage) to a principal sum; and
- Interest accrues on a daily basis.
Interest is a capital expenditure and certain provisions in the Income Tax Act permit interest deductibility. For example, paragraph 20(1)(c) specifies that for interest to be deductible, the amount must be pursuant to a legal obligation and the amount must be reasonable. Further, borrowed money must be used for earning income from business or property.
Direct Use of Borrowed Funds
The courts have stated that the Act requires tracing the use of the borrowed funds to a specific eligible use. If a direct link can be established between the borrowed money and an eligible current use, the money is considered to be used for the purpose of earning income from a business or property. For example, if a taxpayer borrows money to invest in rental property, the interest paid is deductible. Conversely, interest on personal credit card debts is not deductible. But there may be circumstances in which an indirect use of borrowed funds allows for interest deductibility, whereas the direct use of borrowed funds does not.
Indirect Use of Borrowed Funds
There are many instances where the indirect use of borrowed funds renders the interest deductible. The direct use of borrowed funds is a simple cause and effect relationship: the borrowed money was used for a purpose that renders the interest deductible. To determine the indirect use of the transaction one must determine if there was an increase or sustainability of economic value of the debtor because of the borrowed funds. The courts have ruled that it may be appropriate to allow a taxpayer to deduct interest on funds borrowed for an ineligible use because of an indirect effect on a taxpayer’s earning capacity.
The Trans-Prairie case stated that interest was deductible on money borrowed to redeem preferred shares of the corporation. The court ruled that the direct use of the borrowed funds was ineligible because there was no current and direct income earning purpose for the borrowed funds. However, the court ruled that the borrowed funds were used to “fill in the hole” left by the redemption of the preferred shares. Therefore, the interest should be deductible.
In other words, if the capital of the business was used as consideration to redeem the corporation’s preferred shares and the borrowing was used to fill in the hole, the interest on the borrowed money would be deductible. The same result would be achieved if the loan was used to redeem the preferred shares and leave the business capital intact.
The Canada Revenue Agency has stated that interest is deductible on borrowed money used to redeem shares or pay a dividend if the loan does not exceed the aggregate of the accumulated profits. The CRA considers accumulated profits to be retained earnings of the corporation.
It is prudent for taxpayers to ensure interest is deductible on large loans. As can be seen by the foregoing examples, determining whether the interest on borrowed funds is deductible is not always a straightforward exercise.
[ TOP ] |