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.

DOCUMENT NUMBER: 2002-016402

DOCUMENT TYPE: Internal Technical Interpretation

Principal Issues:

1. Does a loan from the shareholders' RRSPs to the non-arm's length corporation constitute a qualified investment for the RRSPs?

2. Is it reasonable for a guaranteed loan from a shareholder's RRSP to the corporation to have an excessively high interest rate?

Position:

1. Question of Fact.

2. No.

Reasons:

1. The status of the investment could be challenged on these facts.

2. The loan is guaranteed. The interest rate should reflect this.

				November 28, 2002

	TORONTO CENTRE TSO			HEADQUARTERS
				Income Tax Rulings
	Attention:  Cynthia Rhodes			  Directorate
				Renée Shields
(613) 948-5273

				2002-016402

XXXXXXXXXX Loan from Shareholders' RRSPs

This is in response to your memorandum of September 16, 2002 inquiring about certain loan arrangements made between XXXXXXXXXX (the "Company") and its shareholders' Registered Retirement Savings Plans ("RRSPs").

Background

The Company has borrowed a total of $XXXXXXXXXX from the RRSPs of its XXXXXXXXXX shareholders, XXXXXXXXXX (collectively, the "Shareholders"). The interest rate affixed to the loans is XXXXXXXXXX%. The Company has executed a Guaranteed Subordinated Note (collectively, the "Notes") to each of the RRSP trustees for the amount borrowed from each RRSP. The XXXXXXXXXX (the "First Bank") has guaranteed the Notes in favour of the XXXXXXXXXX RRSPs while the XXXXXXXXXX (the "Second Bank") has guaranteed the Note in favour of XXXXXXXXXX's RRSP. Each of the Shareholders has executed a personal guarantee in favour of the guarantor of the Note to their respective RRSP.

You have asked three questions, which we will address in the order in which you have posed them.

Question #1

Should the notes be considered qualified investments for the Shareholders' RRSPs considering that it is the Shareholders who have ultimately guaranteed the loans?

Response

Subparagraph 4900(1)(i)(i) of the Income Tax Regulations (the "Regulations") provides that a bond, debenture, note or similar obligation of a Canadian corporation is a qualified investment provided the payment of the principal amount of the obligation and interest on the principal amount is guaranteed by a corporation whose shares are listed on a prescribed stock exchange. In our view, the guarantee requirement exists to ensure that deferred income plans invest in corporate debt instruments that are subjected to minimum risks. This is one of the primary purposes of restricting the investments that could be held by deferred income plans.

As noted above, chartered banks (collectively, the "Banks") whose shares trade on a prescribed stock exchange guaranteed the RRSP loans to the Company. Consequently, on the surface, the Notes appear to satisfy the condition in subparagraph 4900(1)(i)(i) of the Regulations. However, we have to consider all of the relevant facts in making this determination.

Firstly, an argument could be made that the Notes guaranteed by the First Bank are not qualified investments for an RRSP. The First Bank guarantees contain the following wording: "XXXXXXXXXX." This wording permits the beneficiary (i.e. the RRSP) to accept an amount less than the full principal and interest due. In other words, the full amount of the Notes and interest is not necessarily guaranteed under the arrangement. Therefore, we can argue that the First Bank guarantee does not satisfy subparagraph 4900(1)(i)(i) of the Regulations.

Secondly, the taxpayers have pointed out that the Company is not a party to the guarantee arrangements with the Banks. It may be possible to argue that the guarantee arrangement between the Banks and the Shareholders does not meet subparagraph 4900(1)(i)(i) because the Company is not a party. This may be a difficult position to defend as the wording in subparagraph 4900(1)(i)(i) may imply that the company must be a party to the guarantee arrangement but it certainly is not explicit on this point.

Thirdly, since the Bank guarantees are secured by the personal guarantees of the Shareholders, we would question whether the Notes are in fact guaranteed by the Banks or by the Shareholders. Again, an argument could be made that this is not a guarantee as contemplated by subparagraph 4900(1)(i)(i) of the Regulations. Because the existence of these personal guarantees might not invalidate an otherwise valid guarantee for purposes of subparagraph 4900(1)(i)(i), it may be very difficult to ignore the Bank guarantees in applying subparagraph 4900(1)(i)(i) of the Regulations.

In summary, it may be very difficult to support a conclusion that the Notes do not satisfy the conditions in subparagraph 4900(1)(i)(i) of the Regulations.

Question #2:

Is this a tax avoidance situation?

Response

This structure could be viewed as offending the object and spirit of the Act. You may wish to pursue this avenue with your technical advisor and/or the tax avoidance program at your T.S.O.

Question #3:

Is it reasonable for the interest rate on the loans to be set at an amount which does not take the guarantees into consideration?

Response

It is our opinion that in light of the bank guarantee of the Notes and interest, an XXXXXXXXXX% interest rate is not reasonable. We have reviewed the explanations provided by XXXXXXXXXX and by the Chief Financial Officer of the Company and are not persuaded that the rate is reasonable when you consider all of the facts in the particular situation. Accordingly, we believe that support for re-assessment can be found on the following grounds:

The Company:

Paragraph 20(1)(c) of the Act permits a corporation to deduct the lesser of the actual interest paid on money borrowed for the purpose of earning income from a business or a reasonable amount in respect thereof. In determining whether an amount is reasonable, we would have to review all of the facts.

In the above situation, we would have to determine whether the Company needed the money borrowed from the shareholders' RRSPs. This determination would require a review of the Company's financial statements. For instance, where the Company did not require the amounts borrowed and the Notes exist solely to pay amounts to the shareholders' RRSPs, we would argue that none of the interest would be deductible to the Company.

In any case, we are of the view that XXXXXXXXXX% interest is not a reasonable rate of interest for Notes that are guaranteed by a chartered bank. Accordingly, the Company would be limited to a deduction for interest paid based on a reasonable interest rate, likely one closer to the prime lending rate. Any deduction for interest paid in excess of a reasonable rate would be disallowed on this basis.

The Shareholders:

Subsection 15(1) of the Act provides that where at any time in a taxation year a benefit is conferred on a shareholder (other than by certain enumerated means that have no application here) the amount shall be included in the income of the shareholder.

As discussed in paragraph 1(b) of IT-432R2, "Benefits Conferred on Shareholders", the word "benefit" in subsection 15(1) is broad enough to include an appropriation of a corporation's funds in any manner whatever for the benefit of a shareholder. In this case, the payment of unreasonable interest by the Company is conferring a benefit on the Shareholders by augmenting their RRSPs. Accordingly, the interest payments in excess of reasonable interest should be taxable to the Shareholders as a shareholder benefit. We find support for this view in the dicta of Judge Linden in Her Majesty the Queen v. Shell Canada Limited, 98 DTC 6177, (FCA) at 6183.

Paragraph 1(a) of IT-432R2, which extends the application of subsection 15(1) of the Act to situations in which a payment is made by a corporation to a shareholder otherwise than pursuant to a bona fide business transaction, also supports the application of subsection 15(1) of the Act. Paragraph 5 of IT-432R2 indicates that a transaction is considered to be bona fide when its terms and conditions are essentially the same as they would be if parties dealing at arm's length entered into the transaction. It is unlikely that the Company would borrow funds at XXXXXXXXXX% interest from an arm's length party.

The RRSPs:

Subsection 204.1(2.1) of the Act imposes a tax of 1% per month on the cumulative excess amount in an individual's RRSP. According to paragraph (b) of the definition of factor "I" in subsection 204.2(1.2), a gift is included in calculating the cumulative excess amount. In calculating a cumulative excess amount, it is our position that an argument could be made that the interest payments received by the RRSP in excess of a reasonable rate of interest constitute a gift to the RRSP.

We trust that these comments will be of assistance.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Customs and Revenue Agency's electronic library. 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 electronic library version, or they may request a severed copy using the Privacy Act criteria, which does not remove client identity. You should make requests for this latter version to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.

Mickey Sarazin, C.A.

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