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 CCRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.
Principal Issues: Whether subparagraph 40(2)(g)(ii) would deny a capital loss, where a shareholder has loaned funds to a corporation interest free?
Position: Likely no.
Reasons: Based on the Byram decision, where a clear nexus between the shareholder and the corporation's dividend income can be demonstrated, subparagraph 40(2)(g)(ii) should not be applied to deny the capital loss.
September 20, 2002
Toronto North Tax Services Office HEADQUARTERS
Arthur Benjamin Karen Power, CA
(613) 957-8953
2002-015133
Subparagraph 40(2)(g)(ii)
This is in reply to your memorandum of July 4, 2002, wherein you request our views on the deductibility of capital losses where subparagraph 40(2)(g)(ii) of the Income Tax Act (the "Act") may be relevant.
The facts as provided by the taxpayer's representative can be summarized as follows:
1. The taxpayer ("Mr. S") was a XXXXXXXXXX% shareholder in XXXXXXXXXX ("Opco") from its incorporation in XXXXXXXXXX until XXXXXXXXXX. During this period, Mr. S was actively involved in managing the affairs of Opco, which had a variety of activities including XXXXXXXXXX . During this period, Mr. S derived a large part of his income from this source.
2. In XXXXXXXXXX, Mr. S transferred his shares of Opco to his holding company, XXXXXXXXXX ("Holdco"). From the date of Holdco's incorporation Mr. S has been the sole shareholder.
3. The remaining shares of Opco were owned by Mr. S's brother-in-law or a holding company wholly owned by his brother-in-law until XXXXXXXXXX. In XXXXXXXXXX, Holdco became the sole shareholder of Opco.
4. From XXXXXXXXXX to XXXXXXXXXX, Mr. S made various advances to Opco and from time to time partial repayments of these advances were made. All advances to Opco were interest free.
5. In XXXXXXXXXX, Opco became technically insolvent and was unable to repay its shareholder loan. As a consequence, Mr. S legally forgave $XXXXXXXXXX of his shareholder loan in XXXXXXXXXX. It is our understanding, that the Toronto North Tax Services office has reviewed documentation relating to this forgiveness. In filing Mr. S's XXXXXXXXXX personal tax return, the forgiven amount was claimed as a business investment loss.
6. The Canada Customs and Revenue Agency ("CCRA") reviewed Mr. S's XXXXXXXXXX tax return and determined that the taxpayer was ineligible to claim either a business investment loss or a capital loss. A reassessment was issued denying such losses.
7. The taxpayer's representative agrees that the amount does not qualify as a business investment loss , however, he has requested a reassessment of the XXXXXXXXXX taxation year on the basis that the taxpayer should be entitled to claim a capital loss established on the forgiveness of the shareholder loan.
8. CCRA has denied the taxpayer's request on the grounds that the capital loss would be denied pursuant to subparagraph 40(2)(g)(ii) of the Act and the conditions established in the administrative guidelines outlined in paragraph 6 of Interpretation Bulletin IT-239R2 have not been met.
Under subparagraph 40(2)(g)(ii) of the Act, a taxpayer's loss arising from the disposition of a debt is nil (and therefore cannot result in a capital loss) unless the debt had been (i) acquired by the taxpayer for the purpose of gaining or producing income from a business or property (other than exempt income); or (ii) acquired as consideration for the disposition of capital property in an arm's length transaction. In accordance with the comments in paragraph 5 of Interpretation Bulletin IT-239R2, if a debt bears interest at a reasonable rate, the debt will generally be considered to be acquired for the purpose of gaining or producing income.
Paragraph 6 of IT-239R2 provides an exception to the general position. That paragraph states:
"Where a taxpayer has loaned money at less than a reasonable rate of interest to a Canadian corporation of which he is a shareholder, or to its Canadian subsidiary, or has guaranteed the debts of such a corporation for inadequate consideration, any subsequent loss arising to him from the inability of the corporation to discharge its obligations to him, or from having to honour the guarantee, may be a deductible capital loss to him despite the absence of a reasonable rate of interest or adequate consideration. Generally it is the Department's practice to allow a loss on such a loan or guarantee and not treat it as being nil by virtue of subparagraph 40(2)(g)(ii) if the following conditions are satisfied:
(a) the corporation to whom the loan was made or whose debts were guaranteed used the borrowed funds in order to produce income from business or property, or used the borrowed funds to lend money at less than a reasonable rate of interest to its Canadian subsidiary in turn to be used to produce income from business or property,
(b) the corporation has made every effort to borrow the necessary funds through the usual commercial money markets but cannot obtain financing without the guarantee of the shareholder at interest rates at which the shareholder could borrow,
(c) the corporation has ceased permanently to carry on its business, and
(d) the loan from the shareholder to the corporation at less than a reasonable rate of interest (or at no interest) does not result in any undue tax advantage to either the shareholder or the corporation.
Where the above conditions are not met, the CCRA has previously opined that the debt cannot be said to have been acquired for the purpose of gaining or producing income even though its acquisition may have been for the purpose of preserving a source of income from the shares of the corporation, consequently subparagraph 40(2)(g)(ii) would have applied to deny the capital loss.
Several recent court decisions have questioned the validity of the comments contained in paragraph 6 of IT-239R2. In holding that certain losses were allowable, the Federal Court of Appeal in the Edwin J. Byram decision (99 DTC 5117) stated:
"The language of 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 (i.e. the lender) and the income, there is no need for the income to flow directly to the taxpayer from the loan.
Such an approach is also consistent with commercial reality. Frequently, shareholders make such loans on an interest-free basis anticipating dividends to flow from the activities financed by the loan...
The ultimate purpose of a parent company or a significant shareholder providing a loan to a corporation is, without question, to facilitate the performance of that corporation thereby increasing the potential dividends issued by the company...
There is a growing body of jurisprudence that considers current corporate reality as being sufficient to demonstrate that the expectation of dividend income justifies a capital loss deduction under subparagraph 40(2)(g)(ii). As articulated above, this approach is consistent with current corporate realities and the purpose of subparagraph 40(2)(g)(ii)...
The shareholders of a company are directly linked to that corporation's future earnings and its payment of dividends. Where a shareholder provides a guarantee or an interest free loan to that company in order to provide capital to that company, a clear nexus exists between the taxpayer and the potential future income. Where a loan is made for the purpose of earning income through the payment of dividends, this connection is sufficient to satisfy the purpose requirement of subparagraph 40(2)(g)(ii).
In situations where the taxpayer does not hold shares in the debtor, but rather is a shareholder of a parent company or other shareholder of the debtor the taxpayer is not entitled to dividend income directly from the debtor. Generally speaking, the burden of demonstrating a sufficient nexus between the taxpayer and the dividend income, in such cases, will be much higher. The determination of whether there is sufficient connection between the taxpayer and the income earning potential of the debtor will be decided on a case by case basis depending on the particular circumstances involved."
The CCRA indicated in Income Tax Technical News #18 that is has accepted the decision in Byram and intended to revise Interpretation Bulletin IT-239R2 to reflect this decision. However, the CCRA would hold such revisions in abeyance until the outcome of the Singleton appeal to the Supreme Court of Canada (SCC). We have now had the opportunity to review the comments contained in the SCC decision in Singleton (2001 DTC 5533). In our view, the direct use test imposed by the Singleton decision should not impact on the interpretation of subparagraph 40(2)(g)(ii) of the Act. Consequently, the CCRA should continue to rely upon the Byram decision.
In the situation described above, provided you are satisfied that the XXXXXXXXXX loan forgiveness resulted in a disposition, a clear nexus between Mr. S. and potential dividend income from Opco can be demonstrated. In our view, the connection is sufficient to satisfy the purpose requirement of subparagraph 40(2)(g)(ii) of the Act. It is our view based on the facts provided, that a connection exists even after XXXXXXXXXX, since Mr. S was at all times the sole shareholder of Holdco.
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.
Milled Azzi, CA
for Director
Business and Partnerships Division
Income Tax Rulings Directorate
Policy and Legislation Branch
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