23 March 2005 Internal T.I. 2005-0117541I7 - Allowable business investment loss

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.

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: Question of fact

Reasons: Based on the Byram decision, where a clear connection 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. It is a question of fact whether such a connection exists.

		March 23, 2005

	SUDBURY TSO	HEADQUARTERS
	Verification and Enforcement	Income Tax Rulings
		  Directorate
	Attention:  George Pitchkur	G. Moore
(613) 957-8982

		2005-011754

Allowable Business Investment Loss

This is in response to your memorandum of February 17, 2005, regarding allowable business investment losses. You have provided the following scenarios for discussion.

Case #1:

Opco, a Canadian controlled private corporation ("CCPC") issued XXXXXXXXXX common shares (XXXXXXXXXX% of capital stock issued & outstanding) to Mr. A upon incorporation in XXXXXXXXXX, for the nominal sum of $XXXXXXXXXX per share. Also upon incorporation, Opco issued XXXXXXXXXX common shares to Mr. B (XXXXXXXXXX% of capital stock issued & outstanding) and the balance of the capital stock issued being XXXXXXXXXX common shares (XXXXXXXXXX%) were issued to Mr. C (XXXXXXXXXX%) and Mr. D (XXXXXXXXXX%). All common shares were issued at a nominal sum of $XXXXXXXXXX per share. Mr. A deals with all of the other shareholders at arm's length. Mr. B is a retired XXXXXXXXXX, residing in Ontario, who met Mr. A, an XXXXXXXXXX, during the years that he was employed as a XXXXXXXXXX. A review of the facts surrounding their relationship has not provided sufficient evidence to support or consider that Mr. A & B were dealing with each other at non-arm's length pursuant to the "question of fact" rule in paragraph 251(1)(c) of the Income Tax Act (the "Act"). Mr. B is related by blood to Mr. C and Mr. D, immediate family members, and therefore these persons are considered to have been dealing at non-arm's length with each other.

Mr. A was approached by Mr. B to participate in the Opco business venture sometime prior to Opco's incorporation, because of his sound technical knowledge of XXXXXXXXXX. Opco would purchase a XXXXXXXXXX and operate a business that would XXXXXXXXXX. The XXXXXXXXXX equipment was ordered in XXXXXXXXXX from a US based company and a non-refundable deposit of $XXXXXXXXXX US was made on placement of the order. The final cost of the XXXXXXXXXX was in excess of $XXXXXXXXXX CDN. Mr. B made non-interest bearing loans (without any terms of repayment) to Opco that were used to make the deposit on the purchase of the XXXXXXXXXX and to cover other start-up costs. These costs included management fees paid to Mr. A for his expertise and advice. Additional costs were incurred for travel and accommodation that were incurred by Mr. B on behalf of Opco to visit Mr. A, who resided in a western Canadian city, for the purpose of discussing and further developing Opco's business plans. Contributions to Opco by shareholders other than Mr. B were nominal and immaterial in amounts and usually reimbursed.

Opco's business venture went sour in XXXXXXXXXX and the corporation became insolvent and ceased operations in XXXXXXXXXX. The order for the XXXXXXXXXX was cancelled and attempts to legally recover any portion of the deposit were unsuccessful. Mr. B claimed an ABIL on his XXXXXXXXXX T1 return. The gross loss claimed in this regard had included his Opco shareholder loan account credit balance in the year ending XXXXXXXXXX that had captured the contributions made to Opco, which represented the approximate balance payable to Mr. B of $XXXXXXXXXX.

You ask whether you should allow a minority shareholder such as Mr. B, to claim a capital loss (ultimately an ABIL) in circumstances where such a minority shareholder has loaned money (or guaranteed funds) at less than a reasonable rate of interest or whether you should only allow XXXXXXXXXX% of the total $XXXXXXXXXX CDN loss.

Case #2

Opco2, a CCPC, has 2 shareholders, Mr. E and Mr. F, each of whom own 40% and 60%, respectively, of the 100% of the issued and outstanding capital stock of Opco2. Mr. E deals at arms-length with Mr. F. Opco2 has operated as an active business for XXXXXXXXXX years. Opco2 declared bankruptcy in XXXXXXXXXX and is unable to repay the debt owed to Mr. E of $XXXXXXXXXX and Mr. F of $XXXXXXXXXX representing non-interest bearing loans made to Opco2. These funds were used in the business operations throughout the years that Opco had operated. Opco2 ceased to carry on business in XXXXXXXXXX. Mr. E claimed a capital loss of $XXXXXXXXXX in his XXXXXXXXXX T1 return which is ultimately deducted from his income as an ABIL.

You ask whether Mr. E, a minority shareholder in Opco2, is entitled to claim the full amount of his capital loss of $XXXXXXXXXX in XXXXXXXXXX or whether the CRA should prorate the gross amount of Mr. E's capital loss to 40% of the actual loss, representing his interest in Opco2, which would ultimately reduce his ABIL, respectively.

Case #3

The facts are identical to those in Case # 2 except that the two shareholders are dealing with each other at non-arm's length.

Our Comments

Case #1

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 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 CRA 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 CRA indicated in Income Tax Technical News #18 that it has accepted the decision in Byram and intended to revise Interpretation Bulletin IT-239R2 to reflect this decision. However, the CRA 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 CRA should continue to rely upon the Byram decision.

In the situation described above, the issue is whether the connection between Mr. B, a minority shareholder, and potential dividend income from Opco, is sufficient to satisfy the requirement of subparagraph 40(2)(g)(ii) of the Act that the loan has to be made for the purpose of earning income. Since Mr. B has only a XXXXXXXXXX% minority interest in Opco and another XXXXXXXXXX % interest in Opco is held by non-arm's length family members, you have indicated that the loan may have been made primarily to provide a benefit to his family members rather than for the purpose of earning income. In addition, you have suggested that at the time the investment was made, it was questionable whether the future dividend stream from his shares in Opco would be sufficient to recoup such a significant loan to the corporation. We agree with your view that there is support for the argument that, when Mr. B provided the $XXXXXXXXXX interest-free loan to Opco, the loan may not have been made for the purpose of earning income through the receipt of dividends. If, based on the facts of the case, you are satisfied that the purpose of the loan by Mr. B was to benefit other family members who are shareholders of Opco rather than for the purpose of earning income through dividends, then the purpose test in subparagraph 40(2)(g)(ii) of the Act would not be met and Mr. B's entire loss could be disallowed.

Case # 2

A clear nexus between Mr. E, a minority shareholder who has a 40% interest in Opco2, and potential dividend income from Opco2 can be demonstrated. In our view, the connection is sufficient to satisfy the purpose requirement of subparagraph 40(2)(g)(ii) of the Act. In addition, it is our view that Mr. E's capital loss should not be prorated based on his share ownership in Opco2.

Case # 3

Our response remains the same as that for Case # 2 above. The fact that Mr. E and Mr. F do not deal with each other at arm's length, does not necessarily mean, by itself, that the loan made by Mr. E was not made for the purpose of earning income. After a review of the facts of a particular fact situation, if you are satisfied that there is a clear nexus between Mr. E and potential dividend income from Opco2, then this connection would be sufficient to satisfy the purpose requirement of subparagraph 40(2)(g)(ii) 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 Canada 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. 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.

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