289 CHAPTER 7 Income From Property Introduction 7-1. _ Subdivision b of Division B of the Income Tax Act provides simultaneous coverage of both income from business and income from property. The parts of these Sections relating to business income are covered in Chapter 6, and many of these provisions are equally appli- cable to income from property. However, there are sufficient features that are unique to income from property that separate coverage of this subject is warranted and is provided in this Chapter. We have also included coverage of some of the basic issues related to interest deductibility in this Chapter. Property Income: General Concept 7-2. Income from property is thought of as the return on invested capital in situations where le or no effort is required by the investor to produce the return. Falling into this category would be rents, interest, dividends, and royalties paid for the use of purchased property. In terms of tax legislation, capital gains are not treated as a component of property income, even in cases where they arise on investments being held to produce property income (e.g., capital gains on dividend paying shares). This point is made clear in ITA 9(3) which states that “income from a property does not include any capital gain ...". 7-3. Incases where a great deal of time and effort is directed at producing interest or rents, such returns can be considered business income. For example, the rents earned by a company that owns a number of shopping centers would be treated as a component of busi- ness income. As explained in Chapter 12, this is an important distinction for corporations since business income qualifies for the small business deduction, while property income generally does not. 7-4, The primary characteristic that distinguishes property income from business income is the lack of effort directed towards its production. However, in some circumstances, other factors must also be considered. Some examples of why the correct classification isimportant are as follows: + When some types of property income are being earned, the deduction of capital cost allowance (CCA) cannot be used to create or increase a net loss for the period + When property income is being earned by individuals, there is no requirement for a pro rata CCA reduction to reflect a short fiscal period.290 Chapter 7 Interest As A Deduction + When property income is being earned, the income attribution rules (see Chapter 9) are applicable. This is not the case when business income is being earned. + Certain expenses can be deducted against business income, but not property income. These include write-offs of cumulative eligible capital and convention expenses. In contrast, for individuals, there is a deduction for foreign taxes on property income in excess of 15 percent that is not available against foreign business income Interest As A Deduction The Problem 7-5. There are differing views on the extent to which interest costs should be considered a deductible item for various classes of taxpayers. At one extreme we have the situation that, at one time, existed in the U.S. In that country it was once possible for individuals to deduct all interest costs, without regard to the purpose of the borrowing. In contrast, there are other tax. regimes where the deductibility of interest is restricted to certain, very specific types of transactions. 7-6. Froma conceptual point of view, it can be argued that interest should only be deduct- ible to the extent it is paid on funds that are borrowed to produce income that is fully taxable in the period in which the interest is paid. The application of this concept would clearly disallow the current deduction of interest when it relates to + the acquisition of items for personal consumption; + the acquisition of assets which produce income that is only partially taxed (e.g, capital gains); or + the acquisition of assets which produce income that will not be taxed until a subse- quent taxation year (e.g., gains on investments in land). 7-7. To some extent, the preceding view is incorporated into the current legislation. The real problem, however, is that there are such a multitude of provisions related to the special treatment of certain types of income and to the deferral of income, that the application of these fairly straightforward principles becomes very complex. 7-8. Asis noted in Chapter 6, the general provision for the deduction of interest is found in ITA 20(1)(c). This provision provides for the deduction of interest only if it relates to the production of business or property income. This means that, in general, interest cannot be deducted if it relates only to such other sources of income as employment income or capital gains. Note, however, that if this production of income criteria is met, the deduction is av: able to all types of taxpayers, including corporations, individuals, and trusts. 7-9. Asafinal general point here, you will recall that when an employee receives an interest free or low interest loan from an employer, imputed interest on the loan will be included in employment income as a taxable benefit. Under ITA 80.5, this imputed interest is deemed to be interest paid and, if the loan is used to produce business or property income, the amount that was included in the employee's income will be deductible under ITA 20(1)(c). Current Situation 7-10. The government has made several attempts to provide more detailed guidance on the question of interest deductibility. In 1991 legislation dealing with this issue was put forward and, while nothing has been done regarding its passage, tax services still list these provisions as proposed 7-11. Asecond attempt at a legislative solution was attempted in 2003. On October 31, 2003, the government released an unusual document which consisted of a combination of draft legislation, along with a new Interpretation Bulletin, 1T-533, Interest Deductibility And Related Issues. With respect to the draft legislation, it is still listed by tax services as proposed. However, the general consensus is that these legislative proposals will never be passed.Income From Property Interest As A Deduction 7-12. The government's inability to gain support for passage of these legislative proposals ‘was made more difficult by two cases in which the Supreme Court Of Canada ruled against the CRA. These were the Singleton and Ludco decisions which the court delivered in 2001 7-13. We are left then with the precedents established in these two cases, along with the guidance provided in IT-533, Interest Deductibility and Related Issues. Our discussion of terest deductibility will be based on these materials and will not deal with the coverage of either the 1991 proposals or the 2003 proposals. The Singleton And Ludco Court Cases 7-14. Two cases that wound their way through the court system in the late 1990s probably had some influence on the willingness of the government to proceed with the 1991 draft legis- lation, as well as on the proposals that were put forward on October 31, 2003. While any thorough analysis of these cases goes well beyond the scope of this text, your understanding of interest deductibility will be enhanced by some awareness of the conclusions reached in these two cases. 7-15. The facts in the Singleton case (The Queen vs. Singleton; 2001 DTC 5533) involved a lawyer who made a withdrawal of funds from his capital account in the law firm where he worked. These funds were used to purchase a residence for his personal use. Immediately after, he borrowed sufficient funds to replace the capital balance that he had withdrawn from his firm and then proceeded to deduct the interest on these borrowings. Mr. Singleton argued that the money borrowed was directly used to invest in the partnership and, because this was an income producing purpose, the interest should be deductible. 7-16. The CRA denied this deduction on the basis that the real purpose of the borrowings was to finance the purchase of his residence, a view that was supported by the Tax Court of Canada, However, both the Federal Court of Appeal and the Supreme Court of Canada disagreed. In making this decision, the Supreme Court noted that, in the absence of a sham or a specific provision in the Act to the contrary, the economic realities ofa transaction cannot be used to recharacterize a clearly established legal relationship. 7-17. The facts in the Ludco case (Ludco Enterprises Ltd. vs. The Queen; 2001 DTC 5505) involved the Company borrowing $7.5 million which was used to finance investments in two offshore companies. During the period that these investments were held, Ludco paid $6 million in interest on the borrowings and received $600,000 in dividends on the shares held. When the shares were ultimately redeemed, Ludco realized a $9.2 million capital gain. 7-18. The CRA denied the deduction of the interest on the grounds that the shares were acquired for the purpose of earning a capital gain, not for the purpose of earning property income. While the Federal Court of Appeal agreed with the CRA, the Supreme Court of Canada did not. They concluded that an investment can have multiple purposes and, as long, as one of these was the earning of property income, the condition that borrowing must be for the purpose of earning income was satisfied. That provision does not require either a quanti- tative determination of income or a judicial assessment of the sufficiency of income in order to satisfy its requirements. IT-533 - “Interest Deductibility And Related Issues” What Is Interest? 7-19. In order to be considered interest for tax purposes, IT-533 indicates that the amount has to satisfy three criteria: + It must accrue on a continuous basis (note that it may be compounded using a different basis). + Itmust be calculated on a principal sum. + It must be compensation for the use of that principal sum. 7-20. _1T-533 notes that participating payments meet this definition and will be deductible, provided there is an upper limit on the applicable rate and that upper limit reflects prevailing 291