It’s How You Use it That Matters

In a recent article in a golfing magazine that I read, a leading light in the golf instruction world started off an article with the observation “Golf is a hard game.” (Hank Haney, “Golf Digest,” January 2013.) If you’re a non-golfer this may seem counter intuitive. After all, the ball isn’t moving before you hit it, so what’s so hard about that? Any golfer will answer “A lot!” It would take a book to list the ways golf can be an almost impossible game to play well. In fact, one of the great dangers facing any serious golfer is the temptation to over analyze the mechanical aspects of the game forgetting that the object of the exercise is hitting the ball, not thinking about hitting it. In an indirect sort of way this brings me around to the subject of today’s post, interest deductibility.

In a recent technical interpretation (TI 2012-0446741E5), the CRA was asked to consider whether interest was deductible by an individual who, owning shares in a corporation, borrows money to invest in a new class of its dividend paying preferred shares. On the surface and if this was all there was to it, there would be no question about the deductibility of the interest paid on that borrowing. Paragraph 20(1)(c) of the tax legislation allows the deduction of interest paid on money borrowed if the borrowed money is “used for the purpose of earning income from… (inter alia) property.” In a series of cases culminating in the Singleton decision (SCC 2001), the Supreme Court has held that interest is deductible if the direct use of the borrowed money is the acquisition of income-producing property. Since dividend paying shares meet this test, interest paid on money borrowed to purchase the shares is deductible. But there is more to the CRA example than a borrowing to fund a straightforward share purchase.

Sometime after the shareholder acquires the preferred shares (the implication is that the time is immediately after the shares are issued), the corporation reduces the capital of those shares to a nominal amount. The shareholder uses the amount paid on the redemption for non-income producing purposes. May the shareholder continue to deduct the interest on the loan? The CRA suggests not. As stated in the TI: “…as the capital is immediately returned to the shareholder, the borrowed money is not used in the corporation’s business. Interest on the loan would not be deductible since the “current use” of the borrowed funds is personal rather than income-producing.” I think this misapplies the “use” test in 20(1)(c).

As the many cases on interest deductibility point out (as well as the CRA itself in Interpretation Bulletin IT-533), the primary test for interest deductibility is the direct use of the borrowed funds. Here, the direct use remains constant – the ownership of the dividend paying preferred shares. The reduction in the paid-up capital of those shares is not a disposition of them for tax purposes, so the direct use test continues to be met. The CRA seems to have confused a secondary test for interest deductibility, the so-called indirect use test.

The indirect use test will allow the deduction of the interest where the primary test is not met, but the borrowed money can be traced to an indirect eligible use. A common example is money borrowed by a shareholder and lent interest-free to the corporation. Because the loan to the corporation does not bear interest, that loan does not meet the direct use test. However, if the corporation uses the money borrowed from the shareholder to earn income, the indirect test is met and the shareholder may deduct the interest paid on the initial borrowing. This seems to be CRA’s approach to the question discussed in the TI. But in the circumstances described there, it is not necessary to go to the indirect use test because the shareholder continues to meet the direct use requirement.

There may be circumstances in which a shareholder ostensibly meets the direct use test when in fact the prospect of dividends being paid on the shares is remote. The CRA has tools to deal with this. Paragraph 20(1)(c)itself has been interpreted to require a “reasonable expectation of income” test which might apply in that event (Ludmer, SCC 2001). Or, there is always the GAAR if the avoidance involved abuses the object and spirit of the interest deductibility provisions. Instead of referring to these, the TI seems to me to confuse the indirect and direct tests for interest deductibility. To return the golfing metaphor, I think CRA has focused on the tax mechanics (the possibility of improper avoidance) instead of applying the straightforward rule that clearly applies here (the direct use test). Indeed, it is a hard game.