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: Will the interest on funds borrowed to invest in common shares of a subsidiary be deductible pursuant to paragraph 20(1)(c) where the sub on-loans the funds on an interest-free basis to a related company?
Position: A strong argument exists that the requirements of 20(1)(c) are not met in this case.
Reasons: The borrowed money was not used for the purpose of earning income from a business or property.
September 6, 2007
HAMILTON TAX SERVICES OFFICE HEADQUARTERS
Eric Loyzer P. Kohnen, CMA
Large Case File 957-2093
55 Bay Street N.
4th Floor, P.O. Box 2220
Hamilton, ON L8N 3E1
2007-024423
Loan transactions within a group of companies
This is in response to your submission that followed our telephone conversation (Loyzer/Kohnen) of July 9, 2007, whereby you requested our comments on the deductibility of interest paid by a Canadian corporation ("Canco#1") on a loan from a related U.S. corporation ("USB Corp").
Our understanding of the relevant facts and transactions in question is as follows:
1. On or about XXXXXXXXXX, Canco#1 borrowed $XXXXXXXXXX (CDN) (the "Original Loan") from USB Corp.
2. The following day, this loan was assigned by USB Corp to a related Canadian corporation ("Canco#2"). Pursuant to the assignment, Canco#2 was required to pay interest in respect of the loan assignment at an annual rate of XXXXXXXXXX % to USB Corp, whereas Canco#1 was obligated to pay interest at an annual rate of XXXXXXXXXX% to Canco#2 in respect of the Original Loan.
3. Immediately following the assignment, Canco#1 invested the U.S. dollar equivalent of the $XXXXXXXXXX (CDN) Original Loan in common shares of one of its wholly-owned non-resident subsidiaries ("USSub#1").
4. It was intended that the funds invested in USSub#1 would, in turn, be invested in a second non-resident subsidiary of Canco#1 ("USSub#2"), however, this second investment did not occur until XXXXXXXXXX.
5. In the interim period from XXXXXXXXXX (the "Interim Period"), USSub#1 lent the funds on an interest-free basis to the parent company of Canco#1 ("US Parent")
You have requested our comments on whether the interest expense deduction taken by Canco#1 in respect of the Original Loan, for the Interim Period, would meet the requirements of paragraph 20(1)(c) of the Income Tax Act (the "Act").
In general, pursuant to subparagraph 20(1)(c)(i) of the Act, a taxpayer may deduct 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, or, if less, a reasonable amount. For the purpose of our comments herein, and given that we have limited facts on which to base our review, we assume that the amount claimed as a deduction by Canco#1 in respect of the Interim Period was paid in the year or payable in respect of the year in which it was deducted. We further assume that a lender/borrower relationship existed between Canco#1 and USB Corp, and that Canco#1 was under a legal obligation to pay the interest. It should also be noted that we have made no effort to assess the reasonableness of the rate of interest applied to the Original Loan.
The relevant issue, thus, is whether the funds borrowed by Canco#1 were used, in the Interim Period, for the purpose of earning income from a business or property.
In the decision in Ludco Enterprises Ltd. et al v The Queen, [2002] 2 CTC 95, it was noted that the requisite test to determine the purpose is whether, considering all of the circumstances, the taxpayer had a reasonable expectation of income at the time the investment was made (see paragraph 9 of Interpretation Bulletin IT-533 - Interest Deductibility and Related Issues). And as is noted in paragraph 31 of that bulletin, interest costs in respect of funds borrowed to purchase common shares will normally be deductible where there is a reasonable expectation, at the time of acquisition, that the shareholder will receive dividends on the shares.
Given that USSub#1 had never paid dividends on its shares, it is questionable whether Canco#1 had a reasonable expectation of income when it invested in the common shares of its subsidiary.
As per the decision in Shell Canada Ltd v The Queen, [1999] 4 CTC 313, and as further supported by The Queen v Singleton, [2002] 1 CTC 121, it is the direct current use of the borrowed money that must be considered in determining whether the purpose test in subparagraph 20(1)(c)(i) is met. Furthermore, in Singleton, it was held that where a sequence of transactions is being considered, it would be incorrect to treat the entire sequence as one simultaneous transaction. Accordingly, one must not focus solely on the interest-free loan from USSub#1 to US Parent when assessing whether the purpose test has been met, but rather, must determine whether the investment in shares of USSub#1 (by Canco#1) had a reasonable expectation of income.
The determination of whether there exists a reasonable expectation of the receipt of dividend income will be a question of fact in each case, and, in our view, can draw upon facts in place at the time of the share purchase, as well as evidence that arose following the share purchase. However, it is noted, based on our telephone discussions (Loyzer/Kohnen), that USSub#1 has never paid any dividends to date, a fact that we find compelling. We would also point out that the fact that the proceeds of the sale of USSub#1 common shares were onloaned to US Parent without any interest charge did not improve the likelihood that Canco#1 would receive dividends on its investment.
It is unclear from the facts provided whether the investment in shares of USSub#1 by Canco#1 represented a start-up capital infusion, or an investment of additional capital. If it constituted the start-up capital, it is clear that loaning of all of these funds on an interest-free basis in the Interim Period would render it impossible for USSub#1 to generate any income with which to pay dividends up to Canco#1. Alternatively, if this investment is an additional infusion of capital by Canco#1, it does not result in the possibility of any incremental income generation for USSub#1 in the Interim Period.
Accordingly, in our view, a strong argument exists that Canco#1 did not have a reasonable expectation of income from its investment in USSub#1 during the Interim Period, and thus, did not meet the purpose test in subparagraph 20(1)(c)(i) of the Act.
We trust that the above comments will be of assistance to you. Please do not hesitate to contact Phillip Kohnen at 957-2093 should you require further information.
Roberta Albert, CA
for Director
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate
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