28 February 2003 Internal T.I. 2002-0164507 - ABIL AND INTEREST DEDUCTIBILITY

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:

The taxpayer corporation borrowed money bearing interest and lent the borrowed money at interest to a company controlled by the same shareholder as that of the taxpayer. The controlling shares in the debtor company were sold for a nominal amount. The loan continued and payments of interest continued to be made after the sale of the shares. A year later, the debtor company went bankrupt. Can the taxpayer claim an ABIL on the loan and an interest deduction under paragraph 20(1)(c)?

Position TAKEN:

1. ABIL: Question of fact when the debt became a bad debt.

2. Interest Deductibility: Question of fact. .

Reasons FOR POSITION TAKEN:

1. ABIL: If the shares of the debtor corporation were disposed of by the controlling shareholder before the debt went bad, then the taxpayer and the debtor corporation were dealing with each other at arm's length at the time the debt became a bad debt.

2. Interest Deductibility: Loss of source

			February 28, 2003

	KINGSTON TSO	HEADQUARTERS
	Verification and Enforcement		Corporate Financing Section
			Income Tax Rulings
	Attention:  Ken Vankerkhoven		Directorate
G. Moore
(613) 957-2747

			2002-016450
	     XXXXXXXXXX 

This is in reply to your memorandums of September 19, 2002, and January 29, 2003, wherein you requested our views regarding the allowable business investment loss and interest deductibility relating to the above-mentioned company.

Further to the conversation (Moore/Vankerkhoven) of February 11, 2003, we understand the situation is as follows:

In XXXXXXXXXX (the "taxpayer") borrowed $XXXXXXXXXX from a life insurance company at XXXXXXXXXX% interest and lent the borrowed money at XXXXXXXXXX% interest to XXXXXXXXXX, ("debtor corporation") a sister company controlled by the same shareholder ("Mrs. X"). The controlling shares in the debtor company were sold for a nominal amount in XXXXXXXXXX by Mrs. X. It appears that the buyer was an arm's length third party. When the shares were sold, the loan continued and payments of interest continued to be made by the taxpayer to the life insurance company. A bankruptcy manager was appointed in XXXXXXXXXX for the debtor corporation, and you indicate that it appears that the debtor corporation went bankrupt at that time, although the activities related to the business are deemed to continue. The taxpayer is claiming an allowable business investment loss (ABIL) on the $XXXXXXXXXX loan under subsection 50(1) of the Income Tax Act (the "Act") for the XXXXXXXXXX taxation year as well as a claim for the reversal of the disallowance of an interest deduction under paragraph 20(1)(c) of the Act in respect of interest payments made by the taxpayer to the life insurance company. On the reassessment where the interest deduction was disallowed, it was not known that the taxpayer was in receipt of interest income of XXXXXXXXXX% on the loan, which was the same rate of interest charged to the taxpayer on the borrowed money from the life insurance company. The final report of the bankruptcy covers the period XXXXXXXXXX.

Our Comments

Interest Deductibility

Interest on borrowed money is deductible pursuant to paragraph 20(1)(c) of the Act where the borrowed money is used for the purpose of earning income from a business or property. Section 20.1 of the Act applies where, because of a loss of source of income, borrowed money ceases to be used for an income-earning purpose. These rules ensure that interest on such borrowed money will, in certain circumstances, continue to be deductible under paragraph 20(1)(c) of the Act provided all the conditions of this paragraph are met. Generally, borrowed money will cease to be used for the purpose of earning income from a property when the taxpayer sells or otherwise disposes of the property. However, in some circumstances, borrowed money may cease to be so used while the taxpayer still owns the property - for example, where a taxpayer has used borrowed money to acquire shares of a corporation that has subsequently become bankrupt.

As you know, on October 1, 2002, CCRA released our preliminary positions on interest deductibility. The key issues relating to interest deductibility involves determining the direct use and current use of borrowed money and identifying an income earning purpose associated with that use. In the situation you described, the issue is whether the taxpayer can deduct interest on money borrowed from the life insurance company. The purpose test in paragraph 20(1)(c) of the Act is to be applied as follows: considering all the circumstances, did the taxpayer have a reasonable expectation of income at the time the borrowed money was loaned to the debtor corporation? Since the taxpayer was charging interest at XXXXXXXXXX% on the loan to the debtor corporation, it appears as if the purpose test is met. The second issue relates to the current use of the borrowed money. Once the debtor corporation became bankrupt, the current use of the borrowed money is no longer for an income-earning purpose, unless there is evidence to the contrary. In summary, it appears that, if the requirements of paragraph 20(1)(c) of the Act are met, the interest on money borrowed by the taxpayer from the life insurance company may likely be deductible until such time as the debtor corporation became bankrupt.

Business Investment Loss

According to paragraph 2 of Interpretation Bulletin IT-159R3, under subparagraph 40(2)(g)(ii) of the Act, a taxpayer's loss arising from the disposition of a debt is nil unless the debt was acquired by the taxpayer for the purpose of gaining or producing income from a business or property. For the purposes of subparagraph 40(2)(g)(ii) of the Act, money which has been loaned at a reasonable rate of interest generally constitutes a debt acquired for the purpose of gaining or producing income, and any capital loss which arises because it has become uncollectible is generally not deemed to be nil by virtue of subparagraph 40(2)(g)(ii) of the Act. The loss arising to the taxpayer from the corporation's inability to discharge its obligations to the taxpayer may be a deductible capital loss if the conditions set out in paragraph 6 of IT-239R2 are satisfied.

A capital loss arising from the disposition of a debt that has become a bad debt may qualify as a business investment loss within the meaning of paragraph 39(1)(c) of the Act if the debt that generated the loss was owed to the taxpayer by a small business corporation and if the disposition of the debt was either to a person with whom the taxpayer was dealing at arm's length or one to which subsection 50(1) of the Act applies. As indicated in paragraph 5 of IT-484R2, Business Investment Losses, a debt owed to a corporation by a non-arms length corporation is excluded from debts owing to a taxpayer from a Canadian controlled private corporation ("CCPC") and therefore any capital loss arising from such a disposition will never qualify as a business investment loss.

Subsection 50(1) of the Act deems a taxpayer to have disposed of a debt at the end of a taxation year for nil proceeds and to have reacquired it immediately thereafter at a cost of nil if, in the case of a debt (other than a debt from the sale of personal use property), the debt is owing to the taxpayer at the end of the taxation year and it is established by the taxpayer to have become a bad debt in the year. If subsection 50(1) applies, the taxpayer is deemed to have disposed of the property for nil proceeds and a capital loss will arise. The time at which a debt becomes a bad debt is a question of fact and any decision made will be dependent upon the circumstances in each case. A determination by a creditor that a debt has become bad in a particular taxation year must be supported by all relevant and material facts. Generally, a debt will not be uncollectible at the end of a particular taxation year unless the creditor has exhausted all legal means of collecting it or where the debtor has become insolvent and has no means of paying it. A debt is considered bad for the purpose of section 50 of the Act only when the whole amount is uncollectible or when a portion of it has been settled and the remainder is uncollectible.

In the situation you describe, for purposes of subsection 50(1) of the Act, at the time that the debt owing to the taxpayer by the debtor corporation was established to be a bad debt, the taxpayer and the debtor corporation were dealing with each other at arm's length since the controlling shareholder of the debtor corporation had disposed of all of her shares in the debtor corporation before the debt became a bad debt so that the comments in paragraph 5 of IT-484R2 are not applicable. The onus is on the taxpayer to establish that the bad debt occurred in XXXXXXXXXX, the year that the debtor corporation was bankrupt. It is a question of fact when the debt became a bad debt. Whether a corporation is a small business corporation and the time at which a debt becomes a bad debt are questions of fact.

It is our view that one of the pertinent issues in this case is the determination of the time when the debt went bad. We agree with your view that if the debt went bad in XXXXXXXXXX, before Mrs. X sold her shares, rather than in XXXXXXXXXX, then the taxpayer would be denied an ABIL because the relationship between the taxpayer and the debtor corporation would have been non-arm's length. If, based on the documentation provided by the taxpayer, you are satisfied that the debt became a bad debt in XXXXXXXXXX, then it is our view that pursuant to subsection 50(1) of the Act, the taxpayer can elect to have subsection 50(1) apply to deem the disposition of the debt at the end of the XXXXXXXXXX taxation year.

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 copy severed using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.

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

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