9 April 2003 External T.I. 2003-0181655 - 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:

Is Interest deductible when borrowing to invest in a sister corporation or other corporation in the chain of affiliated group of corporations?

Position TAKEN:

Exceptional Circumstances- must show income earning purpose
REASON FOR POSITION: 20(1)(c)

									2003-018165
XXXXXXXXXX 								C. Tremblay, CMA
(613) 957-2139
April 9, 2003

Dear XXXXXXXXXX:

Re: Interest deductibility

This is in reply to your electronic message of November 28, 2002, wherein you asked whether borrowing to make interest free loans to other corporations in an affiliated group (such as a sister company or at another level in the corporate chain) are generally acceptable.

Our Comments

Written confirmations of tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an Advance Income Tax Ruling request. Where the particular transactions are completed, the inquiry should be addressed to the relevant Tax Services Office. However, we are prepared to provide the following comments.

Interest on borrowed money to make an interest-free loan is not generally deductible since there is a direct ineligible use, as no income will be generated from the loan. However, we would generally accept the deduction of interest on borrowed money used to make an interest-free loan to a wholly-owned corporation (or in cases of multiple shareholders, where each shareholder makes an interest-free loan in proportion to their shareholdings) where the proceeds will be used by the corporation to produce income, thereby increasing the potential dividends to be received. Interest deductibility in other situations involving borrowing to make interest-free loans may also be warranted depending upon the particular facts of a given situation. For example, a taxpayer may be able to show that there is an indirect eligible use even where an interest-free loan is made to another corporation within a corporate group, other than a wholly owned subsidiary. Such was the case in The Queen v Canadian Helicopters (2002 DTC 6805) in which case the Court found that interest payments tied to a direct ineligible use may still be deducted where the borrowed funds can be traced to an eligible purpose and use, that is, where the taxpayer can establish both a bona fide purpose and intention to use the funds to earn income.

Paragraph 20(1)(c) of the Act permits the deduction of an amount paid in the year or payable in respect of the year, pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from a business or property. In our view, the placing of an interest rate on inter-corporate debt would generally meet the direct use test. The Supreme Court in Ludco has indicated that the purpose test is to be applied as follows: considering all the circumstances, did the taxpayer have a reasonable expectation of income at the time the investment was made (absent a sham, window dressing or other vitiating circumstances).

On February 18, 2003, as part of the presentation of the Federal budget, the Department of Finance published the following statement concerning the deductibility of interest:

"Recent court decisions have raised uncertainties as to how taxpayers are to treat expenses, in particular interest, in computing income from a business or property for purposes of the Income Tax Act. Most notably, these decisions could lead to inappropriate tax results where a taxpayer derives a tax loss by deducting interest expenses, even if under any objective standard there is no reasonable expectation that the taxpayer would earn any income (as opposed to capital gains), or where the presence or the prospect of revenue (as opposed to income net of expenses) is enough to conclude that an expenditure was incurred "for the purpose of earning income".

Neither of these results is consistent with appropriate tax policy, nor would they have been generally expected under prior law and practice. Therefore legislative amendments to the Income Tax Act will be considered in order to provide continuity in this important area of the law. Before finalizing any proposals, however, the Department of Finance will release them for public consultation, with a general goal of ensuring that they restore continuity with the expected consequences before these recent court decisions."

While we hope our comments are of assistance to you they do not address all of the potential income tax implications nor do they constitute an advance income tax ruling and therefore are not binding on the Canada Customs and Revenue Agency.

Yours truly,

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