Canada - English

Interest Not Deductible on Bare Trustee's Refinancing Plan - by Raphael Barchichat 

Canadian Tax Adviser


September 18, 2012


Raphael Barchichat
Montreal, International Corporate Tax


In a recent technical interpretation, the CRA comments on the deductibility of interest from income earned from real estate held by a bare trustee. The CRA states that the corporate shareholders of the bare trustee cannot use funds from a new bank loan to "return capital to" or "repay loans from" themselves, likely making interest expense paid on that new loan non-deductible for tax purposes.

A Canadian corporation (Bare Trustee) was formed to own a rental property (Property) situated in Ontario as a bare trustee. All of Bare Trustee's shareholders are Ontario companies (ON1 and ON2) for income tax purposes.


Bare Trustee financed its purchase of Property with a mortgage from a financial institution (Bank1) and $1 million in funds provided by ON1 and ON2.


While Bare Trustee is the registered owner of Property, ON1 and ON2 report the rental income and expenses (including the interest paid on the mortgage) generated from Property for income tax purposes.


Property's fair market value has increased so that ON1 and ON2 can borrow an additional $300,000 loan (New Loan) from a bank (Bank2).


The CRA was asked to comment on whether ON1 and ON2 could deduct interest paid on New Loan for tax purposes, if the funds were used to return capital to or repay loans from ON1 and ON2.


Legislative background
A taxpayer can deduct interest paid or payable in the year on borrowed money used to earn income from a business or property, under paragraph 20(1)(c) of the Act. "Borrowed money" is generally interpreted to require a relationship between a lender and a borrower, as noted in paragraph 8 of interpretation bulletin IT-533, "Interest Deductibility and Related Issues".


Generally, the CRA considers the direct use of borrowed money when determining whether its related interest is deductible. However, interest paid on a loan taken out to redeem shares or return capital can be an exception to the direct use of borrowed money test, as discussed in paragraph 23 of IT-533. In this case, often referred to as the "fill-the-hole" concept, the borrowed money must replace capital that was used for purposes that would have qualified for interest deductibility had the capital been borrowed money.


Subsection 20(3) of the Act provides, in general terms, that where a taxpayer uses borrowed money to repay previously borrowed money, the new borrowed money is considered to be used for the same purpose as the originally borrowed money.


CRA comments
The CRA noted that it appears that ON1 and ON2 are currently deducting the interest on the mortgage because their view is that they are earning income from the funds used to acquire Property.


The CRA stated that, to the extent that ON1 and ON2 can currently deduct the interest on the mortgage, if the funds from New Loan were used to repay a portion of the mortgage, interest paid on New Loan would be deductible as long as Property continued to be held for the purpose of earning income from a business or property under subsection 20(3).


However, if the funds from New Loan were used for another purpose, the CRA said that the related interest would be deductible only to the extent that ON1 and ON2's use of the funds met the requirements of paragraph 20(1)(c). In the CRA's view, ON1 and ON2's direct use of the New Loan funds could not be to "return capital to" or "repay loans from" the Bare Trustee shareholders because they could not "return capital to" or "repay loans from" themselves.


For more information, contact your KPMG adviser.





Information is current to September 18, 2012. The information contained in this publication is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation. For more information, contact KPMG’s National Tax Centre at 416.777.8500.


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