10 May 2001 Internal T.I. 2001-0069497 - Thin capitalization rules

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: Does subsection 18(4) apply to loan interest capitalized pursuant to subsection 18(3.1)?

Position: Not currently.

Reasons: Previous position taken. However, proposed amendments to subsection 18(3.1) applicable to outlays and expenses incurred after December 21, 2000 will ensure that only the interest not subject to the 18(4) limitations will be allowed to be capitalized.

		May 10, 2001

Toronto Centre Tax Services Office HEADQUARTERS
Section 443-2-7 Karen Power, CA
(613) 957-8953
Attention: Darren Pinette
2001-006949

Thin Capitalization Rules

We are replying to your memorandum of February 2, 2001 in which you requested our opinion on the application of subsection 18(4) of the Income Tax Act (the "Act") in the following situation.

The facts, as we understand them, are as follows:

• The taxpayer is a Canadian-controlled private corporation, incorporated on XXXXXXXXXX and is XXXXXXXXXX% owned by a non-resident trust in the UK.
• The taxpayer's primary business is real estate development and its inventory consists of land and buildings.
• The non-resident shareholder loans money and charges interest to the taxpayer. The taxpayer has incurred interest costs payable to its shareholder since its inception and has capitalized this interest to form part of the cost of its inventory. All interest payable to the non-resident shareholder has been accrued. (As discussed, we have assumed for purposes of our reply that the interest is not deductible by virtue of the application of subsection 18(3.1) of the Act.)
• The taxpayer did not deduct any interest payable to its non-resident shareholder until it first sold a part of its inventory in XXXXXXXXXX.
• The taxpayer's "outstanding debts to specified non-residents" within the meaning of subsection 18(5), has exceeded the limitations contained in subsection 18(4) of the Act in each taxation year.

Our Comments

Subsection 18(4) of the Act applies in respect of an "amount otherwise deductible, in computing its income for the year in respect of interest paid or payable by it on outstanding debts to specified non-residents". Generally the term "deductible" means capable of being deducted. Therefore an amount is considered to be deductible in the year it is capable of being deducted. In our view, an amount not deducted by virtue of subsection 18(3.1) of the Act, as it is currently worded, will not be considered to be a "deductible" outlay. Accordingly, if the taxpayer has no option as to whether or not to deduct an expense, that is, he must capitalize the outlay, the amount will not be considered "deductible".

In our view, subsection 18(4) of the Act, can only apply to amounts "otherwise deductible" and therefore would have no application in the year inventory is eventually sold to restrict deductibility of any capitalized amounts pursuant to subsection 18(3.1) of the Act.

From a tax policy perspective, it would appear that subsection 18(3.1) of the Act is intended to allow for the capitalization of only those soft costs that, if not for that provision, would otherwise be deductible. For example, subsection 18(3.1) of the Act should not apply to those "soft costs" that would otherwise be non-deductible pursuant to paragraphs 18(1)(a), (b) and (h) of the Act. We also assume, from a tax policy perspective, that a provision that is intended to permanently deny a deduction of a particular amount (e.g. subsection 18(4)) would override a provision that would operate to capitalize that amount (eg. subsection 18(3.1)). The policy behind the interaction of subsections 18(4) and 21(1) of the Act (see paragraph 11 of Interpretation Bulletin IT-59R3 and former subsection 18(7) of the Act) would appear to support our understanding that subsection 18(4) of the Act is intended to override subsection 18(3.1) of the Act.

We have in the past considered an "object and spirit" interpretation of the law but concluded that the words "otherwise deductible" in subsection 18(4) of the Act and the nonexistence of those same words in subsection 18(3.1) of the Act could not be ignored. We could not give the same interpretation to the interaction of subsections 18(4) and (3.1) of the Act as is given on the interaction of subsections 18(4) and 21(1) of the Act. Subsection 21(1) of the Act is worded so that the amount that can be capitalized is restricted to the amount that, "but for an election under this subsection in respect thereof, would have been deductible in computing the taxpayers income...". We note that because of the above wording in subsection 21(1) of the Act subsection 18(7) of the Act was repealed (i.e. it was superfluous).

The above noted tax policy has been verified by the recent proposed amendments contained in the March 13, 2001 Notice of Ways and Means Motion. The proposed amendment to paragraph 18(3.1)(b) ensures that the amount of an outlay or expense relating to construction period soft costs is only included in the cost or capital cost of the relevant building to the extent that the amount would otherwise be deductible in computing the taxpayer's income. The amendment applies to outlays and expenses made or incurred after December 21, 2000.

Thus interest incurred after December 21, 2000 may only be capitalized to the extent that it is not restricted by subsection 18(4) of the Act.

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 CCRA'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 severed copy 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.

We trust our comments will be of assistance.

for Director
Reorganizations and Resources Division
Income Tax Rulings Directorate
Policy and Legislation Branch