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: When a court orders the guarantor of a corporate loan to honour the guarantee, and where the amount ordered by the court is interest bearing, can the guarantor claim a deduction pursuant to paragraph 20(1)(c) of the Act, for the court ordered interest, i.e., is the post-judgment interest deductible?
Position: No.
Reasons: The court ordered post-judgment interest is payable in respect of an amount owed by the corporation as guarantor, and this amount owed is not borrowed money for the purposes of subparagraph 20(1)(c)(i). The amount owed by the corporation as guarantor is not considered to be a continuation of the corporate loan that had been guaranteed nor a second loan.
If the guarantor borrows money to honour the guarantee, interest payable on that borrowing may be deductible if the guarantor is able to show an income earning purpose associated with the borrowing.
March 12, 2012
International and Large Business Directorate Headquarters
Compliance Programs Branch Income Tax Rulings
1, Front Street West, 3rd floor Directorate
Toronto ON, M5J 2X6 V. Srikanth
(613) 952-9853
Attention: Sylvie Landry 2011-039872
Interest Deductibility
This is in response to your request of January 6, 2011, wherein you requested our views on the deductibility of interest, and specifically on the application of the provisions of section 20.1 of the Income Tax Act (the “Act”), to the situation described below. We further acknowledge numerous items of correspondence since that date as well as discussions (Landry/Srikanth), during which the views expressed below were verbally provided to you.
Based on the information you provided, it is our understanding that certain corporations (the “Corporations”) held land and building (the “Properties”) in their capacity as ‘nominee corporation’. The beneficial owners of the said properties were two individuals (the “Taxpayers”). The Taxpayers entered into a co-tenancy agreement and had an equal and undivided interest in the Properties held in the Corporations. Two creditors, XXXXXXXXXX (collectively, the “Creditors”), provided financing for the purchase and development of the Properties held in the Corporations. The financing was secured by mortgages on the Properties and was guaranteed by the Taxpayers.
When the Corporations defaulted on the payment of both the principal and interest on the mortgages, the Creditors requested the Courts for an appointment of a receiver in order to settle the outstanding amounts (XXXXXXXXXX was appointed on XXXXXXXXXX as the Receiver and Manager).
Around this same time in XXXXXXXXXX , one of the Creditors, XXXXXXXXXX , took legal action against the Taxpayers, in their capacity as the guarantors of the loan, and against the defaulting Corporations. The Ontario Court of Justice issued a judgment (the “Court Order”), dated XXXXXXXXXX , ordering the Corporations as well as the guarantors (i.e., the Taxpayers) to pay the amounts owing towards the mortgage (principal and interest, the “Judgment” amount). The Judgment itself also was interest-bearing, i.e., there is post-judgment interest.
In XXXXXXXXXX , a Sale and Purchase Agreement was finalized under which the Properties were acquired from the Corporations by the Creditors in settlement of part of the Judgment. Although the Court approved this Sale and Purchase Agreement on XXXXXXXXXX , the actual date of sale of the Properties was not provided to us. Subsequent to the actual date of acquisition, there would have been some amount of the Judgment remaining, though no Properties were held by the Corporations.
It is our further understanding that the Taxpayers have been claiming a deduction for the interest that is accruing on the Judgment, and no attempt has been made to repay either the Judgment or the interest accruing thereon.
You would like our views on whether the Taxpayers are entitled to deduct the interest accruing on the Judgment, i.e. the post-judgment interest.
In summary, in our view, the Taxpayers are not entitled to deduct the interest accruing on the Judgment, i.e., the post-judgment interest, and our reasons, therefore, follow.
We recognize that you submitted much documentation with the request. However, we are only responding to some very narrow technical queries with respect to the situation.
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. Also, subsection 20(3) of the Act provides that when a taxpayer uses borrowed money to repay an existing debt, the borrowed money is treated as having been used for the same purpose as that of the money previously borrowed but repaid.
Accordingly, with respect to the post-judgment interest, we needed to consider whether the Judgment amount itself, that is the amount that the Taxpayers as guarantors were ordered to pay, is borrowed money by being either a continuation of the first loan, or possibly a second loan, such that the provisions of paragraph 20(1)(c), and possibly subsection 20(3), might apply to provide for the deduction of the post-judgment interest.
The following were the comments provided by the Insolvency and the Administrative Law Section of the Income Tax Rulings Directorate regarding this issue (see the enclosed document 2011-041115):
“The judgment is neither a second loan nor a continuation of the initial loan. A judgment is the decision or sentence of a court in a legal proceeding. In the instant case, it is the final determination by the court of the rights and obligations of the litigants. A taxpayer, who makes a payment under a guarantee of indebtedness of a corporation, will generally be considered to have acquired the rights of the creditor in respect of the indebtedness at the time of payment.”
Based on this, in our view, the Court Ordered Judgment amount to be paid by the Taxpayers as guarantors, is not considered to be a borrowing of the Taxpayers such that one of the basic requirements for the deductibility of the interest payable on that amount, that is the post-judgment interest, has not been met. Accordingly, the post-judgment interest does not qualify for a deduction under the provisions of paragraph 20(1)(c) of the Act.
Given the fact that the Properties were acquired by the Creditors during the settlement process such that the source of income disappeared, and the fact that the Taxpayers, as guarantors to the loan, were called upon by the Courts to honour their guarantee, you wanted our views on whether section 20.1 of the Act would be applicable to this situation thereby allowing the Taxpayers to deduct the post-judgment interest pursuant to paragraph 20(1)(c) of the Act.
Section 20.1 of the Act contains rules that apply where, because of a loss of source of income which occurs after XXXXXXXXXX , borrowed money ceases to be used for an income-earning purpose. The ‘disappearing source rules’ in section 20.1 ensure that interest on such borrowed money will, in certain circumstances, continue to be deductible under paragraph 20(1)(c), by deeming the portion of the borrowed money that has been lost to continue to be used for the purpose of earning income from the property. Consequently, that portion of the borrowed money will satisfy the use test in subparagraph 20(1)(c)(i) of the Act, and the property will continue to be considered a source of income of the taxpayer even though the taxpayer may have disposed of it.
In our view, the provisions of section 20.1 do not apply to the given situation. Firstly because, as indicated in 2011-041115, “[t]he judgment is neither a second loan nor a continuation of the initial loan”. Hence, there is no ‘borrowed money’ for the purpose of claiming an interest expense deduction. Secondly, the provisions of section 20.1 are applicable only to transactions which occur after XXXXXXXXXX . In the given situation, based on the information provided, it is not clear if the sale of the Properties occurred after XXXXXXXXXX .
However, it should be noted that if the Taxpayers borrowed funds to settle the Court Ordered Judgment amount to be paid by them to honour the guarantee, they may be able to claim a deduction pursuant to paragraph 20(1)(c) of the Act, depending on the facts of the case, for the interest paid or payable on those borrowings.
Paragraph 33 of the Interpretation Bulletin, IT-533 entitled ‘Interest Deductibility and Related Issues’, describes interest deductibility with respect to borrowed money used to honour guarantees as follows:
“A taxpayer who provides a guarantee in respect of a debt may be called upon to honour the guarantee. In these situations, the guarantor acquires a property (by right of subrogation) that is a claim on the defaulting party for the amount paid on the guarantee. However, there is generally no income element payable in respect of this property.
Where providing guarantees is part of a taxpayer's business (i.e., for a fee), interest expense on borrowed money to honour the guarantee would generally meet the requirements of deductibility under paragraph 20(1)(c).
Where providing guarantees is not part of a taxpayer's business, the direct use of borrowed money to honour a guarantee is generally not for an income earning purpose and such interest would not be deductible….
In certain situations there could be exceptions to the direct use rule. Where the taxpayer can show that the guarantee was given for the purpose of increasing its income-earning capacity and must subsequently borrow money to honour the guarantee, the borrowed money may be considered to be used for the purpose of earning income….There may be other situations where the taxpayer can demonstrate that the indirect use test is met. Such would be the case where a parent company guaranteed the debts of its wholly owned subsidiary (or in cases of multiple shareholders, where shareholders guarantee a loan in proportion to their shareholdings) and can show that it reasonably expected to earn income from the transaction, such as in the form of potential increased dividends to be received….”
Accordingly, in the given instance, if the Taxpayers borrowed funds to settle the Court Ordered Judgment amount to be paid by them, and they are able to show that the guarantee on the initial loan was for an income earning purpose, then it is possible that the interest on the borrowing may be deductible pursuant to paragraph 20(1)(c). You may refer to the comments made by Linden J.A. in 74712 Alberta Ltd (formerly Cal-Gas & Equipment Ltd) v The Queen [1997] 2 FC 471, in disallowing interest expense pursuant to paragraph 20(1)(c). The issue in this case was whether interest payments made by the appellant on a loan of $1.7 million from Wells Fargo Bank, used by the appellant to discharge its guarantee of the indebtedness of its parent corporation, Trennd Investments (1979) Ltd. (Trennd), were deductible pursuant to subparagraph 20(1)(c)(i) of the Act.
Further, with respect to such borrowings, as explained in 2011-041115, the Taxpayers may be eligible to claim either a capital loss subject to the provisions of subparagraph 40(1)(g)(ii) or an allowable business loss (“ABIL”), provided the conditions set out in paragraph 39(1)(c) are complied with and subject to the provisions of subsection 39(12). Since this is a question of fact, based on the information provided to us, we cannot make this determination at this time. However, some of the jurisprudence that you may consider while making this determination are Bourget v The Queen, 2010 TCC 642 and Poirier v. Her Majesty the Queen, [2000] T.C.J. No. 672, Abrametz v The Queen, 2009 DTC 5083.
You were also concerned with whether there are any circumstances wherein an interest deduction pursuant to section 20.1 and paragraph 20(1)(c) of the Act could be claimed for an unlimited period of time in situations where no payment is actually made towards interest or principal of an outstanding debt. In our view, some of the provisions of the Act which counter such situations are the debt parking rules under subsections 80.01(6) to (8), the statute-barred debt rules pursuant to subsection 80.01(9), and rules for unpaid amounts under subsection 78(1) or section 79.1, where property is seized by a creditor in respect of a debt. The facts of a particular situation will determine which of the above-noted provisions may apply.
For your information, unless exempted, 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 the taxpayer request a copy of this memorandum, they may request a severed copy using the Privacy Act criteria, which does not remove taxpayer identity. Requests for this latter version should be made by you to Mrs. Celine Charbonneau at (613) 957-2137. In such cases, a copy will be sent to you for delivery to the taxpayer.
R.A. Albert, CA
For Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch
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