Principal Issues: Will interest on money borrowed and loaned to a sister corporation (to fund its expansion) be deductible under: Scenario 1 - loan to sister bears no interest; or Scenario 2 - loan to sister bears nominal interest?
Position: Scenario 1: Based on the facts. Scenario 2: Generally, yes but must consider draft section 3.1 of the Income Tax Act.
Reasons: Scenario 1: In exceptional circumstances, indirect use must show income earning purpose as noted in paragraphs 22 - 26 of IT 533.
Scenario 2: Income earned need not be in excess of interest paid as noted in paragraph 10 of IT 533, but must consider draft section 3.1 of the Income Tax Act.
XXXXXXXXXX 2006-021678
L. Carruthers, CA
September 7, 2007
Dear XXXXXXXXXX:
Re: Interest Deductibility - Indirect Eligible Use under Exceptional Circumstances
This is in reply to your letter of November 10, 2006, wherein you asked our assistance to clarify the interest deduction that would be allowed pursuant to the Income Tax Act (the "Act") in two scenarios involving money borrowed and re-loaned to a sister corporation.
Our Comments
It appears that the situation outlined in your letter involves an actual fact situation relating to a proposed transaction. Written confirmation of the tax implications inherent in an actual proposed transaction are given by this Directorate only where the transactions are the subject of an advance income tax ruling request submitted in a manner set out in Information Circular IC-70-6R5. As stated in paragraph 22 of IC-70-6R5, technical interpretations are not income tax rulings and, accordingly, are not binding on the Canada Revenue Agency (the "CRA"). The following comments are, therefore, of a general nature only.
Interest on borrowed money is deductible for purposes of the Act if it meets all the requirements of paragraph 20(1)(c) of the Act. Paragraph 20(1)(c) of the Act provides notably that the borrowed money must be used for the purpose of gaining or producing income from a business or property. In Bronfman (87 DTC 5059), the Court held that, "The interest deduction provision requires not only a characterization of the use of the borrowed funds, but also a characterization of "purpose". Eligibility for the deduction is contingent on the use of borrowed money for the purpose of earning income." For a taxpayer to deduct interest under this provision the purpose of borrowing the money must have been to earn income and the borrowed money must have been used directly in an eligible manner to produce this income. Therefore, in order to determine whether borrowed money has been put to an eligible use, it is necessary to determine the use of the borrowed money and the purpose of the borrowing.
Scenario 1
Loan to sister corporation bears no interest.
Interest on borrowed money to make an interest-free loan is generally not deductible since there is a direct ineligible use, as no income will be generated from the loan. However, as reflected in paragraph 25 of Interpretation Bulletin IT-533, entitled "Interest Deductibility and Related Issues", we would generally accept the deduction of interest on borrowed money used to make an interest-free loan to a wholly-owned corporation (or in cases of multiple shareholders, where each shareholder makes an interest-free loan in proportion to their shareholdings) where the proceeds will be used by the wholly-owned corporation to produce income, thereby increasing the potential dividends to be received by the parent corporation (or in cases of multiple shareholders, the shareholders).
Interest deductibility in other situations involving borrowing to make interest-free loans may also be warranted depending upon the particular facts of a given situation. For example, a taxpayer may be able to show that there is an indirect eligible use which meets the purpose test even where an interest-free loan is made to another corporation within a corporate group, other than a wholly owned subsidiary. Such was the case in Canadian Helicopters (2002 FCA 30) where the Federal Court found that interest payments tied to a direct ineligible use may still be deducted where the borrowed funds can be traced to an indirect eligible purpose and use, that is, where the taxpayer can establish both a bona fide purpose and intention to use the borrowed money to earn income. Specifically, in that case, a subsidiary borrowed money and loaned it interest free to its parent, which in turn loaned money to its parent (the "2nd tier parent"). The second tier parent then purchased shares of a competitor. The Federal Court found that although the subsidiary's direct use of the borrowed money was for an ineligible use (interest-free loan to its parent), it had proven exceptional circumstances for which its indirect use was eligible. It was found that the true purpose of the loan arrangement was to allow the 2nd tier parent to purchase shares of a competitor resulting in benefits to the subsidiary such as management arrangements between the subsidiary and the competitor, increased business income to the subsidiary and less competition.
Scenario 2
Loan to sister corporation bears nominal interest.
In our view, based on the Supreme Court's comments in Ludco (2001 SCC 62), where it was indicated that, "For the purposes of s. 20(1)(c)(i), "income" refers to income subject to tax, not net income. ... Absent vitiating circumstances, courts should not be concerned with the sufficiency of the income expected or received", the placing of an interest rate (even a nominal rate) on inter-corporate debt would generally meet the direct use and purpose tests as noted in paragraphs 10 and 31 of IT-533.
However, we would bring to your attention the following Department of Finance statement concerning the deductibility of interest and other expenses which was published on February 23, 2005, as part of the presentation of the Federal budget:
"In October 2003, the Department of Finance released for public consultation a package of legislative proposals regarding the deductibility, for income tax purposes, of interest and other expenses. The proposals responded to certain court decisions that departed significantly from what had been the accepted understanding of the law in this area.
In computing income from a business or property, a taxpayer can deduct many kinds of expenses, provided they were incurred in order to earn the income. A familiar example is interest on borrowed money, which is deductible only if the borrowed money is used for the purpose of earning income from a business or property.
In this context, "income" had been understood to be a net amount comparable to profit, and to exclude capital gains. The court decisions, however, took a different view: income was read as the equivalent of gross revenue, and the distinction between income and capital gains was blurred.
The 2003 proposals were intended to restore the law on these points to its more familiar and more appropriate state.
An extended period of public consultation on the proposals ended in August 2004. Many commentators expressed concerns with the proposals' structure: in particular, that the proposals' codification of an objective "reasonable expectation of profit" test might inadvertently limit the deductibility of a wide variety of ordinary commercial expenses. The Department of Finance has sought to respond by developing a more modest legislative initiative that would respond to those concerns while still achieving the Government's objectives. The Department will, at an early opportunity, release that alternative proposal for comment. This will be combined with a Canada Revenue Agency publication that addresses, in the context of the alternative proposal, certain administrative questions relating to deductibility."
It is our understanding that the Department of Finance continues to receive submissions on the draft legislation and intends to address the concerns raised prior to enacting it. Regardless of the outcome of the alternative proposal noted above, in our view, interest on borrowed money to make a nominal interest loan may be deductible where the borrowed funds can be traced to an indirect eligible purpose and use, that is, where the taxpayer can establish both a bona fide purpose and intention to use the borrowed money to earn income as commented on in Scenario 1 above.
We trust that our comments will be of assistance.
Yours truly,
R.A. Albert, CA
For Director
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate
