The CRA stated 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.
- 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.
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.
Read a September 2012 report prepared by the KPMG member firm in Canada: Interest Not Deductible on Bare Trustee's Refinancing Plan