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 funds borrowed to make an interest free loan.
Position: Not deductible
Reasons: The recipient of the interest free loan has no independent source of income to fund dividends on the lender's shares thus the lender cannot be borrowing for the purpose of earning net income.
XXXXXXXXXX 2000-000831
C. Savage
Attention: XXXXXXXXXX
March 29, 2000
Dear Sirs:
Re: Interest Deductibility
This is in your reply to your letter of February 14, 2000 in which you requested a technical interpretation concerning interest deductibility in a hypothetical fact situation that you described as follows:
Assumed Facts
1. Targetco is a company incorporated under the Canada Business Corporations Act. Targetco's shares are held as follows:
Holdco (owned by management) 36%
Others (vending shareholders) 64%
2. The management of Targetco intend to buy-out the other shareholders ("Others") using bank borrowings.
3. Holdco will incorporate a subsidiary ("Acquireco") and subscribe for 99 common shares for nominal consideration.
4. Targetco will subscribe for one share of Acquireco for nominal consideration.
5. To avoid reciprocal shareholdings between Targetco and Acquireco, Acquireco will incorporate a subsidiary company, Subco, for nominal cash consideration.
6. Targetco will borrow funds from an arm's length bank. The loan will bear interest and reflect commercial terms.
7. Targetco will use the funds received from the bank to make an interest free loan to Acquireco.
8. Acquireco will use the funds received from Targetco to make an interest free loan to Subco.
9. Subco will use the funds received from Acquireco to purchase the shares of Targetco owned by Others.
Interpretation requested
You have requested that we confirm your view that Targetco will be entitled to deduct the interest it pays on the bank loan. In your view paragraph 7 of Interpretation Bulletin IT-445 supports this conclusion.
Our Opinion
The particular circumstances in your letter on which you have asked for our views appears to be a factual situation involving a specific taxpayer. As explained in Information Circular 70-6R3, it is not this Directorate's practice to comment on proposed transactions involving specific taxpayers other than in the form of an advance income tax ruling. Should your situation involve a specific taxpayer and a completed transaction, you should submit all relevant facts and documentation to the appropriate district taxation office for their views. However, we are prepared to offer the following general comments which may be of assistance.
In the circumstances described above interest paid by Targetco would not be deductible under subsection 20(1)(c) of the Income Tax Act. The funds borrowed by Targetco were not used by it for the purpose of earning income from a business or property. There is no potential in the situation that you describe for Targetco to increase its income earning capacity. Any dividends paid on the Acquireco shares will be funded by Targetco itself. As was the case in CRB Logging Ltd. (99 DTC 840), the closed nature of the income flow makes it virtually impossible for Targetco to receive dividends that will not originate from its own business activities. Hence, Targetco cannot have a reasonable expectation that the borrowing from the bank will yield income in excess of the interest expense.
Paragraph 7 of IT-445 outlines an administrative exception to the general rule that interest is not deductible on funds borrowed for the purpose of making an interest free loan. This exception is not available unless the borrower has an income earning purpose for making the interest free loan. Where the subsidiary has no source of income independent of the borrower, this condition cannot be met.
We trust that these comments will be of assistance.
for Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch
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