Interest expense deduction gemerally allowed for income tax purposes under very specific conditions

In the income tax world, the interest expense deduction saga reads like a very bad serialized novel
– one most readers would have long since tossed aside. Although greatly simplifying the issue,
interest expense is generally deductible for income tax purposes under the following conditions:

1. the interest was paid or payable in the year in accordance with a legal obligation, and
2. the borrowed funds were used for the purpose of earning income from a business or property – property income being defined as interest, dividends, rents and royalties but not capital gains.
   
   Not surprisingly, to be deductible, interest expense must be considered reasonable in the circumstances.

Where the deductibility of interest expense was concerned, all was relatively quiet until 1987 when the Supreme Court of Canada (SCC) rendered a decision in a case generally referred to as the Bronfman Trust case. At that time, certain comments contained in the decision cast doubt on the administrative position of the Canada Customs and Revenue Agency (Revenue Canada as it was then known).

In the Bronfman case the SCC held that it was the use made of the borrowed funds that determined whether or not interest expense was deductible for tax purposes. This led to the “tracing principle” wherein the onus was on the taxpayer to trace the use of the borrowed funds to an eligible use. Furthermore, it was the current use of the borrowed money and not the original use that was key to the interest deductibility issue. Essentially, this decision required taxpayers to follow or trace the borrowed funds to an eligible source to ensure interest deductibility was retained.

While the “tracing principle” sounds logical, it really only works well where borrowed money is directly applied to a given use. Often borrowed money is used for numerous purposes – oftentimes some that are clearly deductible and for others that are not. This commingling of borrowed money can make if very difficult, in not impossible, to trace money through to its various uses.

Nonetheless, the “tracing principle” provided the lay of the land until slightly more than one year ago when the SCC rendered a decision in case known as Ludco. At issue in this case was whether the taxpayer had borrowed money for the purpose of earning income from property. CCRA argued that because the interest expense the taxpayer sought to deduct was greatly in excess of the income from the investment, the deduction of interest expense should be denied.

In its decision on Ludco the SCC introduced the “linking principle” wherein, after considering all the circumstances, the question to be asked is whether the taxpayer had a reasonable expectation of income at the time the investment was made. Notice the use of the word “income” and not “profit” – the latter term being what’s left after the deduction of related expenses. In simple terms, the Ludco decision basically says that if an income earning purpose is associated with the direct use of the borrowed funds then interest expense should be deductible for tax purposes.

It’s now been fifteen years since the Bronfman decision and CCRA finally appears ready to provide some clarity to their position on interest deductibility. Last month officials from CCRA presented a discussion paper to the Canadian Tax Foundation on the deductibility of interest. The paper outlines CCRA’s take on the matter and provides situations where they will consider interest to be deductible and, of course, situations where they would seek to deny the deduction of interest expense. The paper calls for comments to be provided by December 31, 2002 with a view to releasing a new Interpretation Bulletin to replace the five existing bulletins. After fifteen years you have to ask why the big rush all of a sudden.

In its discussion paper, CCRA states “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”.

CCRA promising to use a “practical approach”, now there’s a first! Will CCRA’s definition of a “practical approach” jive with the average taxpayer’s understanding of the phrase? Only time will tell but in my next article I’ll summarize the situations addressed in CCRA’s discussion paper and you can be the judge.