17 May 2000 External T.I. 1999-0011345 - Costs of Construction

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues: Where borrowed funds are used by Corp 1 to acquire shares in a subsidiary (Corp 2) and such funds are subsequently loaned by Corp 2, at an interest rate in excess of the rate on original borrowing, to another corporation(Corp 3) to build a building, can it be said that the original borrowing is subject to subsections 18(3.1) and (3.2)?

Position: Yes.

Reasons: If Corp 2 is only single purpose corp it would be our position that funds have been used to indirectly assist the construction of the building and as such 18(3.2) and (3.1) would apply.

XXXXXXXXXX 								1999-001134
S. Tevlin
Attention:  XXXXXXXXXX 

May 17, 2000

Dear Sirs:

Re: Application of Subsections 18(3.1) and (3.2) of the Income Tax Act (the "Act")

We are writing in response to your letter dated May 26, 1999 wherein you requested our opinion with respect to the following hypothetical situations.

Scenario A

There are three related resident corporations, each of which is a taxable Canadian corporation. Corporation A borrows funds from a bank and uses the funds to invest in share capital of Corporation B. Corporation B uses the funds to make a loan at fair market value rate of interest to Corporation C. Corporation C uses the funds to construct a building. The interest rate charged by Corporation B to Corporation C is slightly higher than the interest rate charged by the bank to Corporation A. It is assumed that the interest is otherwise deductible to Corporation A pursuant to paragraph 20(1)(c) of the Act.

Scenario B

Same as A above except that only Corporation A is resident in Canada.

Issue:

Is the interest expense paid by Corporation A not deductible by virtue of subsection 18(3.1) and paragraph 18(3.2)(b) of the Act? A direct tracing of the funds would indicate that the borrowed money has been used to assist, indirectly, Corporation C to construct a building.

Discussion:

It is our position that where Corporation B's only purpose is to act as a conduit for the funds from Corporation A, then it can be said that the interest paid by Corporation A is in respect of borrowed money that may be reasonably considered to have been used to assist indirectly Corporation C to construct a building and would therefore be subject to subsections 18(3.1) and (3.2) of the Act. We are not prepared to accept the argument that the interest expense of Corporation A relates to the capitalization of Corporation B and the earning of interest income by Corporation B. However, other situations involving the flow of funds through tiered corporate structures may have different results depending on the facts and circumstances of the particular situation.

In the situation where Corporation B is not interposed between Corporation A and C, i.e., where Corporation A holds shares of Corporation C as a "specified shareholder", any interest deduction denied pursuant to subsections 18(3.1) and (3.2) of the Act would be added to the adjusted cost base of the Corporation C shares held by Corporation A pursuant to paragraph 53(1)(d.3) of the Act. It is the existence of Corporation B as an intermediary that precludes this tax basis addition for Corporation A.

In any event the interest expense paid by resident Corporation C would be disallowed as an expense pursuant to subsection 18(3.1) of the Act and capitalized under paragraph 18(3.1)(b) of the Act.

The forgoing comments are given in accordance with the practice referred to in paragraph 21 of IC-70-6R3, and are not binding on the Canada Customs and Revenue Agency.

We trust our comments will be of assistance to you.

Yours truly,

Paul Lynch
for Director
Resources, Partnerships and Trusts Division
Income tax Rulings Directorate
Policy and Legislation Branch

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