Interest Deductibility Restrictions - Expecting Too Much from REOP?

Document Type

Article

Publication Date

2004

Source Publication

Canadian Tax Journal

Keywords

Interest Deductibility, Tax Shelters, Tax Avoidance, Losses

Abstract

This paper reviews the policy case for restrictions on the deduction of interest expense as a necessary background to an assessment of the Department of Finance's recent proposal to establish the reasonable expectation of profit (REOP) standard as a statutory requirement for the recognition of losses. The author argues that the proposed statutory standard is defensible as a response to straddle transactions whereby taxpayers combine a borrowing and an asset acquisition with roughly offsetting expected cash flows. These transactions are profitable solely because of the tax benefit that they generate through the inconsistent tax treatment of the expected cash flows associated with the offsetting positions. In the tax policy context, straddle transactions have no desirable consequential attributes and should not be tolerated. With some suggested fine-tuning, the department's proposed statutory REOP standard can provide a target-effective response that should deter straddles. However, in addressing non-straddle transactions that are perceived to have consequential atributes comparable to those of straddle transactions, the proposed standard is hopelessly underinclusive (but also overinclusive in some respects). The author suggests that if the policy problem presented by an unrestricted interest expense deduction is considered to extend to a range of non-straddle transactions, deductibility restrictions patterned on the investment interest and passive loss rules in the United States are the only defensible response. However, as he points out, much of the controversy in the literature regarding interest deductibility restrictions focuses on the policy arguments for restrictions in the context of non-straddle transactions. Straddle transactions present a much clearer case for restrictions along the lines of the proposed statutory REOP standard.

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