Translation disclaimer
This translation was prepared by Tax Interpretations Inc. The CRA did not issue this document in the language in which it now appears, and is not responsible for any errors in its translation that might impact a reader’s understanding of it or the position(s) taken therein. See also the general Disclaimer below.
Principal Issues:
1. Is interest on money borrowed to subscribe for shares still deductible following a reduction in the stated capital?
2. Does interest on borrowed money that was used to make a capital contribution to a partnership continue to be deductible following a distribution of that contribution?
Position:
1. and 2., not if the funds obtained are not used to earn income.
Reasons:
A link between the borrowed money and the capital or capital contribution repaid must be made.
XXXXXXXXXX 2005-015689
L. J. Roy, CGA
May 11, 2007
Dear Sir,
Subject: Interest deductibility
This is in response to your fax of October 31, 2005, in which you asked whether interest on borrowed money will continue to be deductible by a taxpayer in the situations described below.
First situation
In connection with the formation of Opco, an individual subscribed for 100 common shares of Opco for $100. Two years after that subscription, the individual borrowed $100,000 from a financial institution and used the borrowed money to subscribe for 50 new common shares of Opco. As a result of that subscription, the individual held 150 common shares with an adjusted cost base and stated capital of $100,100. A few years after that latter subscription, the corporation paid $100,000 to the individual as a reduction in the stated capital of the common shares. Immediately after that reduction, the adjusted cost base and stated capital of the 150 common shares was $100 and their fair market value was $400,000. The individual did not use the amount received to repay his loan, but rather used it for personal purposes.
Second situation
The individual is one of three partners in a general partnership (SENC). The book value (partner's equity) attributable to the individual's interest in the partnership is $50,000. The fair market value of the individual's interest in the SENC is $160,000. The individual originally borrowed $40,000 from a financial institution to provide his contribution to the SENC. The SENC makes a distribution of the $100,000 capital contribution to each partner. The individual uses this amount for personal purposes and keeps the $40,000 loan from the financial institution outstanding. After the distribution by SENC, the book value of the individual's interest is negative $50,000 but the fair market value of his interest is $60,000.
Unless otherwise indicated, all statutory references herein are to provisions of the Income Tax Act.
As stated in paragraph 22 of Information Circular 70-6R5 dated May 17, 2002, we generally do not provide written opinions on proposed transactions otherwise than by way of advance rulings. Furthermore, the determination of whether a completed transaction has received the appropriate tax treatment is a matter for the Tax Services Offices. We can, however, offer the following general comments which we hope will be helpful.
Subparagraph 20(1)(c)(i) allows the deductibility, in computing a taxpayer's income, of interest paid or payable pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from a business or property.
The jurisprudence indicates that it is the current use of the borrowed money rather than the original use of the borrowed money that determines whether the interest is deductible. For that purpose, there must be a direct link between the borrowed money and the current eligible use.
In the situations described above, it is our view that a direct link should be made between the borrowed money and the funds received on the return of capital or contribution. Consequently, interest would not continue to be deductible since the amount received as a return of capital or contribution is not used for an eligible purpose.
These opinions are not advance decisions and, as stated in paragraph 22 of Information Circular 70-6R5 of May 17, 2002, are not binding.
Best regards,
Ghislain Martineau
Manager
Financial Sector and Exempt Entities Section
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate
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