On October 31, 2003, the Canadian Department of Finance released amendments to the Canadian Income Tax Act which, if implemented in their proposed form, could significantly affect the treatment of losses under the Act and, in particular, losses from the deduction of interest.
The proposed amendments are in response to three pro-taxpayer decisions of the Supreme Court of Canada. The first is Ludco Enterprises Ltd. v. The Queen. In that case, several Canadian individuals and private corporations borrowed money to purchase shares of two Panamanian investment companies. The investment strategy of the offshore companies was to acquire debt securities and reinvest most of their profits, with a relatively small amount of earnings being paid out as dividends. One advantage to the taxpayers of this investment was that income accumulated in the offshore companies was not taxed in Canada and, on the ultimate disposition of the taxpayers’ investment, the proceeds would be taxed as a capital gain. This tax planning is now addressed in the current rules in the Act dealing with offshore investment fund properties and the proposed rules for investments in a "foreign investment entity" (FIE). In Ludco, however, the issue was the deductibility of the taxpayers’ interest expenses.
For Canadian income tax purposes, interest is deductible if it is paid on borrowed money used for the purpose of earning income from a business or property. In Ludco, the taxpayers incurred approximately $6 million in interest charges and earned approximately $600,000 in dividends. Their capital gain on the ultimate disposition of the shares was approximately $9.2 million. The Crown argued that "income" meant net income after interest expenses and excluding capital gains. The Supreme Court of Canada decided that the term meant gross income and that the test for interest deductibility was whether, considering all the circumstances, the taxpayer had a reasonable expectation of income in the form of dividends. Since the offshore companies paid dividends, this requirement was met.
REASONABLE EXPECTATION OF PROFIT
In Brian J. Stewart v. The Queen, the taxpayer was an individual who purchased four rental condominiums on a highly-leveraged basis. This investment yielded a loss to the taxpayer, mainly from the deduction of interest. The issue was whether the taxpayer could deduct these losses against his income from other sources.
For Canadian tax purposes, losses are deductible only if they are from a "source" of income, such as a business or an income-producing property. The Crown argued that, for this purpose, a taxpayer does not have a source of income unless the activity is carried on with a "reasonable expectation of profit" (REOP),whereas the taxpayer in Stewart was projected to earn losses from the activity and was motivated to realize a capital gain on ultimate sale. Again, the Supreme Court of Canada found in favour of the taxpayer. In the Court’s view, whether or not a taxpayer has a source of income is determined by looking at the commerciality of the activity. In this context, REOP is not relevant unless the activity has a personal or hobby element. The Court also said that a motivation to realize a capital gain is consistent with a commercial purpose and does not negate the existence of a source of income.
The third case is The Queen v. Jack Walls and Robert Buvyer, which was decided at the same time as Stewart. In this case, the issue was the deductibility of losses allocated to limited partners in a partnership that acquired and operated a mini-warehouse. Here, the Crown also argued that the losses were not deductible by the limited partners on the basis that the partnership did not have a REOP and, therefore, did not have a loss from a source.
The Supreme Court of Canada disagreed, saying that it was self-evident that the partnership activity was commercial in nature. Since there was no evidence of any element of personal use or benefit in the operation, REOP was not relevant.
THE DRAFT AMENDMENTS
In the 2003 Canadian federal budget, the Department of Finance said that these decisions could lead to "inappropriate tax results" and announced that it was considering amendments to the Act to return to what was "generally expected under prior law and practice." Draft amendments to the Act were released on October 31, 2003.
Under the draft amendments, a taxpayer will be entitled to deduct a loss for a year from a business or property only if, in the year, it is reasonable to expect that the taxpayer will realize a cumulative profit from that business or property for the period in which the taxpayer has carried on, and can reasonably be expected to carry on, that business or has held, and can reasonably be expected to hold, that property. For this purpose, "profit" will not include a capital gain or loss.
It was proposed that this amendment would be effective for taxation years beginning after 2004. In the meantime, the public was invited to provide their comments. A number of submissions have been made by tax professionals and industry organizations.
There are two major complaints about the draft amendments. One is that they could apply to legitimate business activities and in circumstances well beyond the prior case law and the current administrative practice of the Canada Revenue Agency (CRA). The second is that they create significant issues with respect to the treatment of borrowed money used to make investments in shares.
DEDUCTIBILITY OF LEGITIMATE BUSINESS LOSSES
The current law in Canada is that interest is deductible where borrowed money is used for the purpose of earning income. Thus, the test for interest deductibility is applied when the borrowed money is used, not necessarily when interest is paid. Deductibility is not revisited so long as there is no change in the use of the borrowed money. Under the draft amendments, however, there would be an annual test for deductibility of any loss where expenses for a year exceed income. Specifically, the focus is on the cumulative overall profitability of the activity for the whole period that it is carried on, e.g., if borrowed money is used to finance a business which is unsuccessful, losses from interest deductibility will be denied in a subsequent year if, in that subsequent year, it is not reasonable to expect that the taxpayer will be able to fully recoup the accumulated net losses from the business to date. This aspect of the draft amendments has been criticized on the basis that the statutory test is out of sync with the commercial reality of how taxpayers make their business and investment decisions. In the real world, the decision to continue a losing business or investment will depend on the taxpayer’s own financial criteria, which may well justify continuing the activity in order to recoup only some of the losses incurred to date. Under the draft amendments, losses are not deductible unless it is reasonable to expect that all existing losses will be fully recouped.
The draft amendments will affect more than interest deductibility. They could apply to deny deductibility of any form of business losses from expenses of any unprofitable venture, such as rents, salaries and other recurring costs, as well as reclamation costs and other costs of closing down the business. They could also apply where a business is consistently carried on in a wholly commercial fashion, but is unsuccessful for reasons beyond the taxpayer’s control.
INVESTMENTS IN COMMON SHARES
Criticisms have also been leveled at the draft amendments in the context of the treatment of interest expense on investments in common shares and other equity securities, such as mutual fund units. At present, the administrative practice of the CRA is to permit interest deductibility on borrowed money used to acquire common shares on the basis that there is a reasonable expectation, at the time the shares are acquired, that the shareholder will receive dividends (see para. 31 of Interpretation Bulletin IT- 533).The Department of Finance Press Release accompanying the proposed amendments suggests that this same theory would allow CRA to continue to permit interest deductibility under the proposed amendments.The legal basis for this is, at best, uncertain. A specific concern is that there will be many circumstances where the dividend return on publicly-traded shares is less than prevailing interest rates so that, if the draft amendments are strictly applied, the capital markets could be significantly affected.
Not only would the draft amendments introduce a fundamental change to the treatment of losses under the Income Tax Act, there are other more technical issues, such as the lack of continuity rules on rollovers, the failure to permit denied losses to be applied against future profits or capital gains from the same source, and the lack of grandfathering.
In the March 23, 2004 Canadian federal budget, the Department of Finance emphasized that its intention was not to legislate a change from prior administrative practice, but noted that some commentators had expressed concern that the proposals could have this effect.This suggests that revisions may well be made before formal amendments to the Act are introduced. As framed, the proposals are unnecessarily broad.
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