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:

(1) Does the exception in paragraph 15(2.4)(f) of the Act, to subsection 15(2) of the Act, apply to a loan from a corporation to an employee/shareholder, used to acquire previously publicly traded shares of the corporation, where the loan is not repayable until the shares acquired are sold, the borrower dies or their employment ends?

(2) Does subsection 15(2) of the Act apply to a loan made pursuant to an "oral" agreement?

(3) Does subsection 15(2) of the Act apply to a loan made to a non-resident shareholder?

(4) Can a promissory note be amended so that the requirements of paragraph 15(2.4)(f) of the Act are satisfied at the time the loan was made?

Position:	(1)   No.	(2)   Yes.	(3)   Yes.	(4)   No.

Reasons:

(1) The three criteria for repayment do not constitute bona fide arrangements for the repayment of the loan.

(2) There is no requirement under subsection 15(2) that the loan be made pursuant to a written agreement.

(3) By virtue of subsection 15(7) of the Act, subsection 15(2) of the Act applies to a non-resident shareholder.

(4) Paragraph 15(2.4)(f) of the Act specifically requires that the repayment arrangements must be made at the same time as the loan is made.

		April 24, 2001

	XXXXXXXXXX  Tax Services Office	HEADQUARTERS
	Verification & Enforcement Division	A. Seidel
	XXXXXXXXXX 	(613) 957-2058

	Attention: XXXXXXXXXX
		2001-006700

XXXXXXXXXX
Shareholder Loans to Acquire Shares

This is in reply to your memorandum dated January 17, 2001 in which you requested our views as to whether loans to certain shareholders of XXXXXXXXXX (the "Company") are excluded from the application of subsection 15(2) of the Income Tax Act (the "Act") by virtue of paragraph 15(2.4)(f) of the Act.

Background

1. The Company is a XXXXXXXXXX.

2. The Company was incorporated in XXXXXXXXXX and has been listed on the XXXXXXXXXX Stock Exchange XXXXXXXXXX. The Company has a XXXXXXXXXX fiscal year end.

3. In XXXXXXXXXX, the Company acquired a block of shares from the XXXXXXXXXX. The shares were held in trust with the intention to offer them to certain shareholders who were also employees of the Company.

4. The Company provided a $XXXXXXXXXX loan to XXXXXXXXXX.

5. The Company provided the following loans to the following shareholders on

XXXXXXXXXX:

XXXXXXXXXX

6. Each of the individuals used the proceeds of the loans to purchase the shares previously acquired by the Company from the XXXXXXXXXX. Each individual paid $XXXXXXXXXX for each of the shares they purchased.

7. Each of the individuals provided a promissory note to the Company and entered into a "Share Pledge Agreement" as security for the promissory note.

8. Each of the loans is non-interest bearing as long as the loan is not in default. The principal portion of each loan is to be repaid in full at the earlier of the date that the borrower sells their shares of the Company, the borrower dies or the borrower resigns or their employment with the Company is otherwise terminated.

9. The termination of XXXXXXXXXX employment with the Company on XXXXXXXXXX resulted in the following amendment to the repayment provisions contained in the promissory note. Instead of becoming repayable at the time his employment was terminated, XXXXXXXXXX the promissory note was amended so that repayment of the loan was not required until:

" XXXXXXXXXX ... "

10. The XXXXXXXXXX letter submitted by XXXXXXXXXX, indicates that, after all of the above transactions were completed, each of the individuals owned XXXXXXXXXX of the outstanding shares of the Company.

Issues

Does subsection 15(2) of the Act apply to each of the loans described in paragraphs 4 and 5 above?

Does subsection 15(2) of the Act apply to loans made pursuant to "oral" agreements?

Does subsection 15(2) of the Act apply to a loan made to a non-resident shareholder?

Does the XXXXXXXXXX amendment to XXXXXXXXXX promissory note cause subsection 15(2) of the Act not to apply?

Can the taxpayer's amend the promissory notes retroactively so that subsection 15(2) of the Act will not apply to the loans described in paragraphs 4 and 5 above?

XXXXXXXXXX

The following is a summary of their arguments:

• There is sufficient basis in subsection 15(2) of the Act and the present circumstances to allow the conclusion that this provision will not be applied.
• Essentially, we ground this position in the observation that repayment arrangements must be reasonable in the circumstances, and that the circumstances are informed by the purpose of the loan, the nature of the acquired property and its relationship to the debtor and the intentions of the parties to the arrangement.
• We believe the circumstances permit a conclusion that bona fide arrangements were made for repayment of the loans within a reasonable time. Moreover, that changes will be made to the affected arrangements to make this abundantly clear before any taxpayer enjoys a benefit augurs in favour of the resolution we propose.
• There is no doubt that in engaging in the transaction, the intention of the executives involved was not to trigger an immediate income tax liability under subsection 15(2) of the Act but to meet the express requirements of the Act such that they would become liable under a loan arrangement subject to bona fide arrangements for the repayment of the loan within a reasonable time.
• Subsection 15(2) of the Act is a provision which is never intended to be applied. Rather, it is intended to dictate the terms under which corporations may lend money to shareholders without subjecting the taxpayer to penalty under the Act. No officer or employee would accept a loan arrangement which immediately triggered a huge tax liability as a result of an income inclusion in the year the loan was received. The individuals involved neither intended nor agreed to such an arrangement. Nor was it the intention of the Company to generate that punitive result.
• The loan was intended to be used and was used to acquire shares of the Company of which the affected individuals are officers and directors. It was intended to meet the requirements of the Act, in particular, the requirement that it be repaid within a reasonable time measured with reference to the use of the funds.
• It is our submission that the loan documentation, while not optimal, permits subsection 15(2) of the Act not to be applied in the present circumstances. Subsection 15(2) is a constructive distribution provision which is intended to apply when there should be tax consequences to the use of company's funds. It assumes that there has been an appropriation, rather than merely a loss of the Company's funds by shareholders. Where a loan has bona fide terms for repayment, that standard is not met. What is reasonable in terms of the maturity of the loan and repayment depends upon the circumstances. In the context of the employment relationship where the purpose of the Company in making the loans available to purchase shares is to commit its senior executives to the company in the form of a share/loan handcuff, the agreement that the liability be repaid when the shares are sold, the individual leaves the employment or dies, is not only a commercially reasonable one, but a sensible and bona fide term of repayment.
• What is a reasonable maturity date depends on the circumstances. In order to have a reasonable term of repayment, it is not necessary that the loan agreement contain a specific number. What is a reasonable commercial term must depend on the relationship of the parties, the purpose for which the money is borrowed and the terms upon which it is repayable. We agree that while the loan document contains reasonable terms for repayment, the documentation prepared by the parties is less than optimal. To clarify the issue, we propose that a term certain for repayment of the loan be inserted in the loan agreement such that the obligation to repay the loan within a fixed period of time is unequivocal.
• That the above arguments are consistent with Technical Interpretation 9725635.

Analysis

Subsection 15(2) of the Act provides, amongst other things, that where a shareholder of a corporation receives a loan from the corporation in a taxation year, the amount of the loan is included in computing the income for the year of the shareholder.

Subsection 15(2.4) of the Act provides certain exceptions where the shareholder is also an employee of the corporation. Provided that it is reasonable to conclude that the loan was received because of the employee's employment, as opposed to the employee's share-holdings, and provided that, at the time the loan was made, bona fide arrangements were made for repayment of the loan within a reasonable time, subsection 15(2) of the Act would not apply to a loan made to an employee, other than a "specified employee" of the corporation, in the following situations:

The proceeds of the loan are used to assist in the purchase of a dwelling to be used for the employee's habitation;

The proceeds of the loan are used to acquire the shares of the corporation making the loan, provided the shares acquired by the shareholder are "previously unissued fully paid shares" of the capital stock of the corporation or a related corporation; or

The proceeds of the loan are used to acquire a motor vehicle to be used by the employee in the performance of their employment duties.

The exceptions in paragraphs 15(2.4)(b) and (d) of the Act are not relevant to the issue we have been asked to address.

The exception in paragraph 15(2.4)(c) of the Act applies where the proceeds of the loan are used to acquire shares of the lender. However, paragraph 15(2.4)(c) requires that the shares being acquired must be "previously unissued fully paid shares" of the corporation. In this particular case, the shares being acquired by the individuals were previously issued shares that the Company acquired on the XXXXXXXXXX. Accordingly, the exception in paragraph 15(2.4)(c) does not apply to these share acquisitions.

Subject to paragraphs 15(2.4)(e) and (f) of the Act, the exception in subparagraph 15(2.4)(a) of the Act applies to any loan made to an employee of the lender provided that the employee is not a "specified employee" of the lender.

Subsection 248(1) of the Act provides that a "specified employee" is "an employee of the person who is a specified shareholder of the person or who does not deal at arm's length with the person". Subsection 248(1) of the Act provides that a "specified shareholder" of a corporation in a taxation year is "a taxpayer who owns, directly or indirectly, at any time in the year, not less than 10% of the issued shares of any class of the capital stock of the corporation". In this particular situation, each of the shareholders identified in paragraph 5 above owns XXXXXXXXXX of the issued and outstanding shares of the Company after all of the transactions are completed. Accordingly, none of these shareholders is a "specified employee" of the Company.

The requirement in subparagraph 15(2.4)(e) of the Act is that "it is reasonable to conclude that the employee ... received the loan ... because of the employee's employment and not because of any person's share-holdings". The determination of whether or not this requirement is met is a question of fact that can only be determined by reviewing all of the pertinent facts surrounding the receipt of a loan by an employee. Based on the content of your submission to us, it would appear that you are satisfied that the loans described in paragraphs 4 and 5 above were advanced to the individuals in their capacity as employees and not in their capacity as shareholders.

The final requirement in subsection 15(2.4) of the Act is contained in paragraph (f) thereof and it requires that "at the time the loan was made ... bona fide arrangements were made for repayment of the loan ... within a reasonable time".

Prior to the XXXXXXXXXX amendment to XXXXXXXXXX promissory note, each promissory note of the loan recipients provided that repayment of the loan would be required, subject to certain conditions relating to the timing of the repayment, at the earliest of:

" XXXXXXXXXX".

With respect to the "timing" of the repayment of a loan where one of the events described under (b) or (c) above occurs, the loan is not repayable until the closing price of the shares on the XXXXXXXXXX is greater than or equal to XXXXXXXXXX.

Our Comments

In Her Majesty the Queen v. Jan Silden, 93 DTC 5362, the Federal Court of Appeal considered the issue of whether "at the time the loan was made ... bona fide arrangements were made for repayment of the loan". In this particular case, the loan was to be used to acquire a dwelling for the borrower's habitation and the repayment arrangements made at the time of the loan provided that the loan would be repayable if and when the borrower left his employment or ceased to be the owner of the house. Pratte, J.A. reversed the decision of the Federal Court - Trial Division that bona fide arrangements had been made for the repayment of the loan and stated the following:

"The finding of the Trial Division with respect to this second condition flows from its conclusion that the understanding that the loan would be repaid if and when the respondent left his employment or ceased to own the house was in the circumstances a reasonable arrangement. That is besides the point. What the statute requires is that arrangements be made "at the time the loan [is] made for repayment thereof within a reasonable time". The real question therefore is not whether the arrangements relating to the repayment of the loan were reasonable but whether, pursuant to those arrangements, the loan was to be reimbursed within a reasonable time. That question cannot, in this instance, be answered in the affirmative since the arrangements that were made at the time of the loan did not permit to determine with any certainty the time within which it had to be reimbursed."

In this particular case, it is our opinion that XXXXXXXXXX. As in the Silden case, these loans are clearly loans where the repayment arrangements made at the time the loans were made do not permit the determination, with any certainty, of the time within which they have to be repaid. Accordingly, the paragraph 15(2.4)(f) exception to the application of subsection 15(2) of the Act does not apply to the loans described in paragraph 5 above.

Conclusion

Each of the shareholders described in paragraph 5 above received a loan from the Company to purchase shares of the Company which the Company had previously purchased on the XXXXXXXXXX. Subsection 15(2) of the Act generally includes the amount of a loan in the income of the shareholder in the year the loan is received. This would include loans that were received pursuant to written or oral agreements and loans to non-resident shareholders. Subsection 15(2.4) provides certain exceptions to this income inclusion. In this particular case, none of these exceptions apply to any of the shareholders described in paragraph 5 above. Accordingly, the following amounts would be included in computing the income of these shareholders. XXXXXXXXXX.

Subsection 212(2) of the Act requires a non-resident person to pay an income tax of 25% on every amount that a corporation resident in Canada pays or credits to a non-resident person as, on account or in lieu of payment of, or in satisfaction of a taxable dividend, as defined in subsection 89(1) of the Act, or a capital dividend, pursuant to subsection 83(2) of the Act. Under paragraph 214(3)(a) of the Act, where subsection 15(2) of the Act would, if Part I of the Act were applicable, require an amount to be included in computing a shareholder's income, that amount is deemed to have been paid to the shareholder as a dividend from a corporation resident in Canada. Therefore, the $XXXXXXXXXX shareholder loan to XXXXXXXXXX would be included in his income as a taxable dividend received from a corporation resident in Canada.

The subsequent amendment to the repayment terms of XXXXXXXXXX promissory note and the proposed amendments to the promissory notes of each of the other shareholders described in paragraph 5 above would not result in the provision of subsection 15(2) of the Act being inapplicable to the loans they received in XXXXXXXXXX. The exception in paragraph 15(2.4)(f) of the Act requires that the bona fide arrangements for repayment of a loan must be made at the same time that the loan was made to the shareholder. In XXXXXXXXXX case, the terms for repayment of the loan were amended in XXXXXXXXXX and the proposed amendment to the other promissory notes would incur in XXXXXXXXXX, whereas the loans were received in XXXXXXXXXX.

The final argument of the shareholders' representative is that the decision in Peter Dale and Bernard Dale v. Her Majesty the Queen, 97 DTC 5252, (FCA) (the "Dale Case") should apply to permit the shareholders to amend their respective promissory note to include therein bona fide arrangements for the repayment of the loans. The situation in the above case is substantially different than in the present case. In the Dale Case, the taxpayer obtained an Order from the Supreme Court of Nova Scotia declaring that its authorized share capital be amended retroactively. The court granted the Order because there was a specific provision in the Nova Scotia Companies Act that enabled the corporation to obtain retroactive amendments to its authorized share capital. The Act does not permit retroactive amendments to a shareholder loan agreement to incorporate bona fide arrangements for repayment of the loan. In fact, the opposite is true in that the Act specifically requires that the bona fide arrangements must be made at the time that the loan is made.

In the XXXXXXXXXX submission from XXXXXXXXXX, she states that "XXXXXXXXXX" It is not clear to us what distinction the representative is trying to make between use of a company's funds and "mere" loss of a company's funds. Nevertheless, in the situation where a shareholder has "appropriated" the funds of a corporation, the loss of the company's funds, whether by theft, embezzlement or in any other manner whatever, these funds are income from a source and as such are taxable in the hands of the recipient. The cash received by the shareholder will be included in computing the income of the shareholder in the year of receipt pursuant to paragraph 3(a) of the Act. Subsection 15(2) of the Act specifically applies, amongst others, in the situation where a shareholder has "in a taxation year received a loan", being the use of the company's funds, from the corporation of which he/she is a shareholder. It is therefore our view that subsection 15(2) of the Act was clearly intended to apply to these loans to the shareholders as described in paragraphs 4 and 5 above.

We hope our comments are of assistance.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Legislation Access Database (LAD) on the Department's mainframe computer. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the LAD version or they may request a copy severed using the Privacy Act criteria which does not remove client identity. Requests for this latter version should be made by you to

Jackie Page at 613 957-0682. The severed copy will be sent to you for delivery to the client.

John Oulton, CA
Section Manager
Business and Individual Section
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Legislation Branch

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