July 2018 Newsletter

Interest expense on borrowed money is deductible for income tax purposes, generally only if the borrowed money is used for the purpose of earning income from a property or business.

For example, if I take out a loan to buy mutual funds, the interest on the loan will normally be deductible. Furthermore, if I later sell the mutual funds and use the proceeds to buy another income-earning property, the interest will remain deductible. On the other hand, if I use the proceeds for personal or non-income earning purposes, such as to pay off my personal credit-card debt or take a vacation, the interest will be non-deductible from that point on.

One of the potential problems relating to these rules arises when you acquire property with a loan and then sell the property at a loss, and use the proceeds for non-income earning purposes or to partially repay the loan. For example, say I borrow $100,000 to buy some shares, later sell all of the shares for $40,000 and use the proceeds to partially repay the loan. Under a strict approach to the above rules, it would appear that $60,000 of the loan ($100,000 minus the $40,000 partial loan repayment) is no longer used for income-earning purposes. This is in fact how the courts interpreted the rules, which eventually led to a specific “disappearing source” rule in the Income Tax Act (section 20.1) that remedies this situation.

As discussed above, interest expense is normally deductible if the borrowed money is used for the purpose of earning income from a business or property. In this regard, the courts have indicated that direct use of the borrowed money is required, and that an indirect use does not qualify.

To appreciate the distinction between a direct use and an indirect use, consider the following example.

There are specific rules under the Income Tax Act that apply to transfers of property between persons who do not deal at arm’s length, which include persons who are related for income tax purposes. When the rules apply, there may be deemed proceeds on the sale, or a deemed cost on the purchase, that differs from the actual proceeds or cost.

Related persons for these purposes include most individuals that you consider your close relatives in a colloquial sense – for example, your children and grandchildren, your parents and grandparents, your siblings, spouses and common-law partners of all of the above, and your in-laws. Interestingly, related persons do not include aunts, uncles, nieces, nephews and cousins.

In terms of corporations, you are related to a corporation if you or a related person control the corporation, or you or a related person are part of a related group that controls the corporation. Control generally means owning more than 50% of the voting shares of the corporation.

As illustrated below, at least two of the rules involving transfers between related persons can be quite onerous.

Overview

There are special rules in the Income Tax Act that allow you to transfer property to a Canadian corporation on a tax-deferred rollover basis. The rules effectively allow you to incorporate an existing business on a tax-free basis, without paying tax on any accrued gains on your business assets. These rules can apply to most transfers of property to a private corporation, not only at the time of incorporation.

This is called a "section 85 rollover", as the rules are found in section 85 of the Income Tax Act.

There are various conditions that must be met.

You and the corporation must file a joint election with the Canada Revenue Agency (“CRA”). The due date for filing the election is your tax filing date for the year of the transfer, or the corporation’s tax filing date, whichever comes first.

Interest deduction denied for return of capital of mutual funds

As discussed earlier in this letter, if you borrow money to purchase mutual funds, the interest expense on the borrowing will normally be deductible in computing your income. However, mutual funds will sometimes pay out a return of your originally invested capital (along with income earned by the funds). If this occurs, the interest deduction may be affected, depending on how you use the returned capital.

In the recent Van Steenis case, the taxpayer took out a $300,000 loan to buy units of a mutual fund. Over the course of several years, approximately 2/3 of this amount was paid out to him as a return of capital. He used most of this amount for personal purposes. The CRA assessed the taxpayer to disallow the interest expense on the portion of the loan reflecting this returned capital that was used for personal purposes.