22 March 2000 External T.I. 2000-0002705 - INTEREST DEDUCTIBILITY - INTEREST FREE LOAN

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: Deductibility of interest on borrowed money that is used to make an interest free loan to a foreign subsidiary.

Position: The interest would not be deductible.

Reasons: Not directly used to earn income from a business or property.

XXXXXXXXXX 2000-000270
B. Kerr
Attention: XXXXXXXXXX

March 22, 2000

Dear Sirs:

Re: Interest Deductibility on an Interest - Free Advance to a Subsidiary

This is in response to your letter of January 10, 2000, to our Vancouver Tax Services Office wherein you requested our views on the interpretation of paragraph 20(1)(c) of the Income Tax Act (the "Act").

You have described a situation where a Canadian resident corporation ("Parentco") owns all of the shares of Subco a U.S. resident corporation. Subco owns all of the shares of Opco another U.S. resident corporation. Parentco borrows money from an arm's length third party and uses the borrowed money to make a non-interest loan to Subco. Subco in turn uses the borrowed money to make a non-interest loan to Opco. The borrowed money is used by Opco in its active business which is carried on outside of Canada.

You have asked whether the interest expense of Parentco on the borrowed money would be deductible . You have made reference to paragraph 7 of Interpretation Bulletin IT-445 and the decision of the Federal Court of Appeal in the Byram (99 DTC 5117) case.

Our Comments

The situation outlined in your letter involves an actual fact situation relating to a proposed transaction. Assurance as to the tax consequences of actual proposed transactions will only be given in the context of an advance income tax ruling. The procedures for requesting an advance income tax ruling are outlined in Information Circular IC-70-6R3 dated December 30, 1996, issued by Revenue Canada. However, we can offer the following general comments.

As stated in paragraph 3 of IT-445, interest expense on borrowed money to be loaned at a reasonable rate of interest is generally deductible. However, interest expense on borrowed money is generally not deductible in whole or in part when that money is loaned interest-free or at less than a reasonable rate of interest or is not used to earn income directly by the borrower in the borrower's business or from a property acquired with that borrowed money. The fact that the borrower may earn income indirectly, for example through increased dividends from a corporation to whom an interest-free loan has been made, is not sufficient cause to permit the borrower to deduct interest on the borrower's liability.

In limited circumstances, as outlined in paragraph 7 of IT-445, the Agency may permit a deduction for the full interest expense when a taxpayer borrows money at interest to be loaned to a Canadian corporation of which the borrower is a shareholder, or to its Canadian subsidiary, at less than a reasonable rate of interest or at no interest. However, this is not the case in the situation you describe.

Although the Byram case dealt with loans to a foreign subsidiary, the main issue dealt with the deductibility of a capital loss from non-interest bearing loans under subparagraph 40(2)(g)(ii) of the Act. In comparing the interest deductibility provisions of paragraph 20(1)(c) to the capital loss provisions of subparagraph 40(2)(g)(ii), McDonald J.A. stated:

"Subparagraph 20(1)(c)(i) allows for the deduction of interest where money is borrowed and then used for the purpose of earning income from business or property. In Bronfman (87 DTC 5059), the Court held that the application of paragraph 20(1)(c) requires an examination and characterization of both the use of the borrowed money and the purpose behind such use. For a taxpayer to deduct interest under this section, the purpose of borrowing the money must have been to earn income and the borrowed money had to be directly used in an eligible manner to produce this income.

In contrast, subparagraph 40(2)(g)(ii) of the Act provides that any capital loss from the disposition of a debt is deemed to be nil, unless the debt was acquired for the purpose of gaining or producing income from a business or property...Unlike paragraph 20(1)(c) this section only requires a single stage inquiry, namely what was the purpose for acquiring the debt. The two stage inquiry laid down in Bronfman clearly indicates that there is a distinction between use and purpose. Therefore, while there are some similarities in the general language of paragraph 20(1)(c) and subparagraph 40(2)(g)(ii), it is significant that section 40 does not contain a "source" directed preamble nor does it refer to use as well as purpose. Accordingly, it would be wholly inappropriate to apply the direct/indirect use limitation imposed by Bronfman to this section.

The language in section 40 is clear. The issue is not the use of the debt, but rather the purpose for which it was acquired. While subparagraph 40(2)(g)(ii) requires a linkage between the taxpayer and the income, there is no need for the income to flow directly to the taxpayer from the loan."

Since in your case the loan is not to a Canadian subsidiary as required by paragraph 7 of IT-445 nor is the borrowed money being used directly by the taxpayer to earn income as suggested in the Bronfman decision and emphasized in the Byram case, it is our view that the interest expense would not be deductible under the provisions of paragraph 20(1)(c) of the Act.

We trust that these comments will be of assistance.

Yours truly,

for Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch