Basic Principles
In general terms, paragraph 20(1)(c) of the Income Tax Act (the “Act”) allows a taxpayer to deduct interest expense paid or payable on borrowed money that is used for the purpose of earning income from a business or property. The “use” and “purpose” requirements for the deduction appear to be straightforward on their face. However, the requirements as applied to specific fact situations are not always straightforward, and have been the subject of various court decisions and Canada Revenue Agency (“CRA”) administrative positions.
The use of the borrowed money is determined for the taxation year or period in respect of which the interest deduction is sought. The courts and the CRA often refer to this use as the “current use” of the borrowed money. Where the current use is for the purpose of earning income, it is often called an “eligible use”, whereas a current use for non-income earning purposes is often called an “ineligible use”.
When property acquired with borrowed money is disposed of and the proceeds are used to acquire another property (or used for another purpose), the use of the proceeds is relevant for the purposes of paragraph 20(1)(c). The former use is irrelevant on a going forward basis.
For example, if I borrow money to acquire a property for income earning purposes that I own throughout year 1, the current use is an eligible use and a full interest deduction is allowed in respect of the borrowed money. If I sell the property at the beginning of year 2 and use the proceeds for income earning purposes throughout year 2, the current use remains an eligible use and the interest deduction is allowed throughout year 2. If instead I use the proceeds for personal or other non-income earing purposes, the current use becomes an ineligible current use and an interest deduction is not allowed in year 2.
What’s the Use?
The use of borrowed money requirement is a misnomer in a way, in that borrowed money itself is typically not used directly for the purpose of earning income from business or property. Rather, it is generally the case that property acquired with the borrowed money (or services paid for with the borrowed money) is used for the purpose of earning income. And, as noted, if the property is subsequently sold and the proceeds are used to acquire another property, the use of the other property is determinative. This tracing rule or “substituted property rule” is not specifically set out in paragraph 20(1)(c), but is rather a principle developed by the courts and most notably the Supreme Court of Canada.[1] It is interesting that paragraph 20(1)(c) does not contain an explicit substituted property rule, as similar rules do apply for other purposes under the Act – an obvious example being the income attribution rules.[2]
In this regard, the recent case of Van Steenis v. The Queen (2018 DTC 1063) raises a unique issue that has not been explicitly addressed by the courts: What happens when a taxpayer continues to own property acquired with borrowed money (that is, there is no disposition), the taxpayer continues to use the property in an eligible use, yet the taxpayer effectively receives back some of the funds used to acquire the property?
In Van Steenis, the taxpayer used borrowed money to purchase units (an interest) in a mutual fund trust. Over the course of several years, the taxpayer received approximately two-thirds of his invested money as a “return of capital” in respect of the units. The receipt of the capital did not result in a disposition of his units in the trust. In other words, he continued to own and use the units in an eligible use, even though he used some of the returned “capital” for a personal and ineligible use. The taxpayer attempted to continue to deduct interest in respect of the entire borrowing. The CRA denied a part of the deduction to the extent the returned capital was used in an ineligible use.
Justice Graham of the Tax Court of Canada held against the taxpayer and denied the deduction. Justice Graham reasoned that “almost two-thirds of the money that [the taxpayer] invested was returned to him. More than half of that returned money was put to use for personal purposes… there was no longer any direct link between those borrowed funds and the investment…the fact that Mr. Van Steenis still owned all of the Units does not change this analysis. Thus Mr. Van Steenis was not entitled to deduct the interest relating to the portion used for personal purposes [emphasis added].”[3]
If the taxpayer in Van Steenis had disposed of all or a part of his units in the trust and received the return of capital as proceeds in consideration for that disposition, it is clear law that his use of those proceeds would be determinative of the interest deduction issue in respect of those proceeds. However, as noted, the taxpayer continued to own his interest and units in the trust. The “return of capital” (not a defined term under the Act) to the taxpayer was a monetization of his investment in the trust without a disposition of the investment. In this regard, the Act clearly contemplates that capital can be “returned” to investors in mutual fund trusts (and certain other non-personal trusts) either in consideration for the disposition of part or all of the investors’ units in the trust, or without any disposition of the units at all.[4]
On an analogous point, money paid on the reduction of the paid-up capital of shares in a corporation held by a shareholder can be paid either on the disposition of the shareholder’s shares, or without a disposition of the shares.[5] The CRA takes that position that where the returned paid-up capital occurs without a disposition of the shares and the capital used in an ineligible use, the interest deduction on a borrowing used to acquire the shares is reduced accordingly.[6] This position is consistent with the finding in Van Steenis.
Tentative Conclusions
In principle, the Van Steenis decision provides the appropriate result. If a taxpayer’s invested capital is effectively returned to the taxpayer, it should be irrelevant whether the original property reflecting that invested capital (i.e. the trust units in Van Steenis) is retained or disposed of by the taxpayer. However, as a legal matter, the issue is perhaps not quite as clear if there is no disposition of the original property.[7]
On a final note, the Van Steenis reasoning should not apply to retained income of a trust for a taxation year that is capitalized and paid to a unitholder or beneficiary as “capital” in a subsequent taxation year. In such case, the receipt of the “capital” by the unitholder does not reflect the unitholder’s original capital invested in the trust, even though it does normally reduce the unitholder’s adjusted cost base in the units in the trust.[8] This scenario is largely irrelevant for unitholders in most Canadian mutual fund trusts, as these trusts pay out their net income on an annual basis. However, the point may be relevant for investments in other non-personal trusts, including foreign commercial trusts,[9] if the trusts do not distribute all of their income on an annual basis.
[1] Tennant v. The Queen, 96 DTC 6121 (SCC).
[2] In terms of loaned money, the attribution rules (e.g. subsection 74.1(1)) explicitly provide that income from the loaned money or property substituted therefore may be subject to attribution.
[3] Paragraph 10 of the Van Steenis decision.
[4] Paragraphs (d) and (h) in “disposition”, subsection 248(1).
[5] Subsection 84(4) or (4.1) applies where there is no disposition of the shares.
[6] Income Tax Folio S3-F6-C1, “Interest Deductibility”, paragraph 1.40.
[7] If a court were to hold contrary to the Van Steenis rationale, the holding might open some floodgates. For example, if Van Steenis is wrong, it might be argued that the withdrawal of a partner’s capital in respect of a partnership interest acquired with borrowed money should not affect the interest deduction in respect of the borrowing, as long as withdrawal does not result in a disposition of the partner’s interest. This type of argument would be difficult to reconcile with decisions dealing with the converse case, namely, where partnership capital is withdrawn without a disposition of the partnership interest and borrowed money is used to replace the withdrawn capital; see Singleton v. The Queen, 2001 DTC 5533 (SCC). One might then consider whether there is a meaningful legal distinction between property rights attaching to units held in a trust and property rights attaching to an interest in a partnership.
[8] Subparagraph 53(2)(h)(i.1).
[9] In this regard, certain foreign commercial trusts are exempt from the non-resident trust rules of section 94, and if so, the retained income of the trusts is not subject to annual taxation in Canada; see paragraph (h) in “exempt foreign trust”, subsection 94(1).
