12 October 2012 External T.I. 2012-0436251E5 - Allowable Business Investment Losses

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: Whether a guarantee of a loan qualifies as an ABIL in the situation described.

Position: A question of fact but probably yes.

Reasons: Consistent with the findings in The Queen v. E. Byram 99 DTC 5117. Probably reasonable to conclude in the situation described that the taxpayer's motivation for the guarantee was to earn dividend income regardless of whether or not he was a direct shareholder of the corporation for which he guaranteed the loan. The ability to earn income indirectly exists.

XXXXXXXXXX
2012-043625
Andrea Boyle, CGA

October 12, 2012

Dear XXXXXXXXXX:

Re: Business Investment Loss - Guarantee

I am writing in reply to your fax dated February 9, 2012 in which you asked us about the deductibility of an allowable business investment loss (“ABIL”) in a particular situation.

Specifically you described a situation where an individual “Mr. A” owns 100% of Company A which in turn owns 50% of Company C. In 2007 Company C obtained bank financing for its operations for which both Company A and Mr. A provided guarantees. Company C ceased operations in 2011. You stated that at that time Company C was a small business corporation. We assume that the guarantors of the bank loan were jointly and severally liable for the entirety of Company C’s outstanding debt. In early 2012, the bank called on Mr. A to repay Company C’s bank debt. You asked whether Mr. A. can claim an ABIL for his repayment of Company C’s bank debt under his personal guarantee.

Written confirmation of the tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R5, Advance Income Tax Rulings, dated May 17, 2002. We are, however, prepared to offer the following general comments, which may be of assistance.

All statutory references in this letter are references to the provisions of the Income Tax Act, R.S.C. 1985 (5th supp.) c. 1, as amended.

Subsection 39(12) states that where an amount was paid to an arm’s length person by a taxpayer in respect of a debt of a corporation under an arrangement under which the taxpayer guaranteed the debt, and the corporation was a small business corporation (within specified time frames), that part of the amount that is owing to the taxpayer by the corporation shall be deemed to be a debt owing to the taxpayer by a small business corporation.

Additionally, in order to qualify as an ABIL a loss must first qualify as a capital loss. The exclusionary clause in subparagraph 40(2)(g)(ii) provides that a taxpayer’s loss, if any, from the disposition of a debt will not be nil if the debt was acquired by the taxpayer for the purpose of gaining or producing income from a business or property.

In The Queen v. E Byram 99 DTC 5117, the court acknowledged that the ultimate purpose of a parent company or a significant shareholder in providing a loan to a corporation is to facilitate the performance of that corporation thereby increasing the potential dividends issued by the company. The court affirmed that the shareholders of a corporation are directly linked to that corporation’s future earnings and its payment of dividends.

Therefore, the court concluded that where a shareholder provides a guarantee without charging a “guarantee fee” or provides an interest free loan to a corporation in order to provide capital to that corporation, a clear nexus exists between the taxpayer and the potential future income

This case considered a situation where the taxpayer does not hold shares in the borrower corporation, but rather is a shareholder of a parent company or other shareholder of the borrower corporation. In such situations the taxpayer is not entitled to dividend income directly from the borrower corporation. The court was of the view that the burden of demonstrating a sufficient nexus between the taxpayer and the dividend income will be much higher in such situations: “The determination of whether there is sufficient connection between the taxpayer and the income earning potential of the debtor will be decided on a case by case basis depending on the particular circumstances involved.”

In the circumstances of this particular court case, the Respondent made loans to a corporation during a period in which he did not own shares in that corporation, but during which he was a shareholder in a corporation which was a shareholder of the borrower corporation. Additionally, the Respondent held shares in yet another corporation which was also a shareholder of the borrower corporation. At all material times, the Respondent and his family were the principal shareholders, officers and directors of the corporations involved.

The court found that the Respondent’s motivation for the loans was consistent regardless of whether he was a direct shareholder of the borrower corporation or not. While the Respondent would not have received dividend income directly from the borrower corporation, the court was satisfied that the connection between the loans and the potential dividend income was sufficient in the circumstances of this case to invoke the exclusionary clause in subparagraph 40(2)(g)(ii).

The fact situation in The Queen v. E Byram 99 DTC 5117 can be compared to the situation which you have described. Mr. A is a 100% owner of a corporation, Company A, which owns 50% of the shares of Company C. (You have not specified who owns the other 50% of the shares of Company C; whether, for example, the other 50% of Company C is owned by members of Mr. A’s family.) However, based on the limited information
provided, it may be reasonable to conclude that Mr. A’s motivation in guaranteeing the loan to Company C was to enable Company C to earn income which could result in dividend income from Company C being paid to Company A and, subsequently, Company A paying dividends to Mr. A.

In other words, there may be a sufficient connection between Mr. A and the income earning potential of Company C to conclude that the exclusionary clause in subparagraph 40(2)(g)(ii) “acquired by the taxpayer for the purpose of gaining or producing income from a business or property” might apply in the situation described.

Based on the limited information you have provided, we are unable to comment on whether or not the corporation otherwise satisfies the criteria for the payment of the loan to be considered an ABIL. For example, whether Company C is a “small business corporation” is a question of fact that depends on the status of the corporation at the time of disposition or in the preceding 12 months.

We trust that these comments will be of assistance.

Yours truly,

Doug Watson
for Director
Corporate Financing Section
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch