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May 19, 2024

Tax Perspectives

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Please note that these publications may not be up-to-date as taxation matters are subject to frequent changes.

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Fall 2001
Volume 1, Number 2

The information in Tax Perspectives is prepared for general interest only. Every effort has been made to ensure that the contents are accurate. However, professional advice should always be obtained before acting and TSG member firms cannot assume any liability for persons who act on the basis of information contained herein without professional advice.

In Brief

By Howard Berglas, CA

Of supreme interest!

It is not often that the Supreme Court of Canada chooses to hear cases involving income tax. So it's not surprising that when it does, it draws the attention of tax practitioners, the CCRA, and the Departments of Justice and Finance.

Two cases were recently heard by the Supreme Court, both involving the deductibility of interest.

In Singleton v. Canada, Singleton, a lawyer, used equity he had in a law firm to purchase a house. On the same day, he refinanced the equity in the law firm with borrowed money, withdrew the money, and bought the house. He claimed the interest as a deduction.

The issue before the court was whether the borrowed money was "used for the purpose of earning income from a business."

The court, in a 5:2 majority decision, rejected the Crown's argument to consider the "true purpose" and the "economic reality" of the series of transactions, which could lead to the conclusion that the purpose of the borrowing was personal.

Instead, the court focused on the interest deductibility provisions of the Act, which in its view require that the direct use of the borrowed funds be for the purpose of earning income from a business or property. Singleton clearly directed the borrowed money toward an investment in the partnership. Everything else was irrelevant and therefore he was entitled to a deduction.

In Ludco Enterprises v. Canada, the Ludmer family sought to deduct interest paid on borrowed money that was used to purchase shares in foreign corporations. The investments were carefully .structured to avoid having to report the income earned by the foreign corporations until it was distributed. During the period in question, the Ludmers received $600,000 in dividends and realized the undistributed income as a large capital gain. They incurred $6 million in interest costs, which they sought to deduct.

The Crown argued that the Ludmers should not be entitled to deduct the interest paid, because they did not reasonably expect to earn income, other than capital gains, while holding the investment. The Crown believed that, since the primary purpose of borrowing to make this investment was to create deductions that exceeded the income expected, the interest deductions should be denied.

The court reaffirmed a well-established principle that it is not the purpose of the borrowing itself that is relevant, but rather the use of the borrowed money. Clearly, the borrowed money was used to buy shares of a foreign corporation. The court noted that the purpose need not be the only or primary purpose, but merely one purpose. Since the investment paid dividends that were subject to tax, the Ludmers had, as a purpose, the earning of income. Finally, the court made it very clear that, for the purposes of the interest deductibility provisions, "income" is not "net income" or "profit" but "gross income," and therefore, "absent a sham, window dressing or similar vitiating circumstances," courts should not be concerned with the amount of income earned or expected to be earned.

These decisions clarify the rules concerning interest deductibility. In the next issue, we'11 review some strategies on how to make your mortgage tax-deductible.

Ontario simplifies corporate tax filings

Starting in 2002, corporations will be allowed to make quarterly instalments instead of monthly instalments, if their Ontario taxes payable in the current or prior year are less than $10,000. Corporations do not have to make any instalments if their tax liability is under $2,000. Corporations filing Ontario corporate tax returns will no longer have to file a copy of their federal T2 for taxation years ending after 2000.

Exemptions from source deductions

Employers have been required to withhold tax on payments made to RRSPs unless a waiver was obtained. Amendments will provide relief for employees and their employers from an unnecessary paper burden on payments made to RRSPs. Under the new rules, employers will not be required to withhold if they believe, on reasonable grounds, that the payments to an RRSP are deductible as an RRSP premium or as an eligible retiring allowance.

US estate tax update

Major changes have been enacted to the US estate tax, which may eventually lead to its complete repeal in 2010 (unless the repeal is repealed).

These changes, however, may provide little benefit to Canadian residents who own US situs assets, since no change has been made to the basic credit that exempts only the first US$60,000 of value from estate tax. US citizens or residents will see their basic credit exempt the first $1 million of value in 2002, increasing in stages to $3.5 million in 2009.

Fortunately, the Canada-US tax treaty may provide relief to Canadians who have a high proportion of their total assets in US assets. The treaty allows them to claim a credit prorated to the credit allowed US citizens and residents. For example, a Canadian who dies in 2002 owning a condo in the United States valued at US$400,000 and who has non-US situs assets valued at US$1.6 million will have one-fifth of the US$1 million exemption, or US$200,000, not subject to US estate tax.

It is unclear whether non-US residents/ citizens who own US situs property will benefit from the repeal of estate taxes in 2010. The general consensus is that they will, but the repeal itself is uncertain. It is probably as important as ever for Canadians who own US property to arrange their affairs so as to minimize their exposure.

Rectification: Correcting your mistakes

The Supreme Court of Canada has decided not to hear an appeal of a decision of the Ontario Court of Appeal in Juliar. That court held that a rectification order may permit a corporate transaction to be altered from inception to reflect the true intention of the parties. Shares were transferred to a holding company for a note. A rectification order was granted so as to replace the note with shares so that the transaction would not result in immediate taxation. This was held to be the intention of the parties.

Making mistakes and then correcting them should not be considered a new approach to tax planning. But if you made a genuine error that created a tax problem, first try fixing the error, which could in turn fix the problem.