S was a successful lawyer with more than $300,000 in equity in his law firm. In 1988 he decided to buy a new house. He drew $300,000 out of his firm to pay for the new house.
At the same time he arranged a loan from a bank to his firm to replace the $300,000 he had drawn from the firm. S claimed the interest paid on the loan as a business expense. This claim was disallowed by Revenue Canada and an appeal ensued that went all the way to the Supreme Court of Canada.
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Some basics: When you borrow money to help your business earn more money, the interest on the loan is generally deductible. So the interest on the line of credit you have to help pay farm operating expenses is deductible.
On the other hand, if you take a loan to buy personal assets such as a house or car, the interest is not deductible.
In this particular case, the question was whether S could deduct the interest on the loan. Revenue Canada denied the deduction. S appealed. The tax court ruled against him saying that “it could not be said the money was used for the purpose of making a contribution of the capital to the partnership. The fundamental purpose was the purchase of a house and this purpose cannot be altered by the shuffle of cheques that took place on Oct. 27, 1988.”
The majority of judges in the Federal Court of Appeal came to a different conclusion. Those judges first pointed out that the benefits of a tax deduction should not be denied simply because the transaction was motivated by tax planning considerations.
Further, the court said there was no evidence of a sham and that what happened were two separate transactions: a business partner drawing his equity from the firm and second, the partner taking a loan to replace the money he had withdrawn.
Revenue Canada appealed to the Supreme Court. The court ruled 5-2 that S should be able to deduct interest payments as an expense. The judges said S was entitled to draw on the $300,000 equity in his firm if he so chose. The equity was not frozen. The court stressed there was no evidence of a sham.
The court also said that if one were buying into the firm, or if the firm was starting up, interest on a loan to buy in would be deductible. Why shouldn’t a person who uses his own money to buy into the firm, withdraw the money and take a loan to replace the withdrawn funds? The court upheld S’s right to deduct the interest.
Two judges dissented and suggested these two transactions should be viewed as one and that it had been done to get a tax
advantage. “His borrowing was not made with the bona fide purpose of generating
income from his business.”
Before you dash out to draw money from the farm, and take a loan to replace it, consider these things. Tax laws are extremely complex and are frequently changed to cover supposed loopholes. Get advice before engaging in any tax avoidance scheme. Finally, take note that the transaction in question occurred in October 1988.
The Supreme Court heard the case in March 2001 and rendered its judgment on Sept. 28, 2001. That’s a long time to wait to find out if your tax deduction will be allowed.
