21 February 1990 Ruling 59363 F - Capitalization of Interest

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.

February 21, 1990

Dear Sirs:

Re:  Capitalization of Interest

This is in reply to your letter of January 3, 1990 seeking our opinion on whether any interest income would be deemed to arise under the Income Tax Act (the "Act") where shares are purchased on an instalment payment basis.

As we understand it, a husband and wife reach a settlement of marital property rights whereby the husband is to pay to his wife $l million for her interest in the husband's company and the wife is to sell her shares to the husband for that price.  The sale is to be accomplished by a tax-free rollover since it is from a husband to a wife pursuant to a settlement.  Although the husband agrees to pay his wife $1 million, he later realizes that he cannot pay it all at once and, accordingly, he and his wife enter into further negotiations and eventually agree that the husband shall pay the $1 million to the wife over a period of four years together with interest at 10%.  After that agreement is reached in principle, the wife requests that the transaction be changed so that the husband pays to the wife the sum of $1,350,000.00 over four years at no interest.  The wife requests this in order to avoid having any interest flow into her hands and in order to make the extra payment of $350,000.00 tax-free to her.  The husband does not intend to claim any tax deduction for the cost of the shares.

You wish to know if the husband agrees to pay $1,350,000.00 with no interest over four years, instead of $1 million with interest over four years, will Revenue Canada, Taxation treat the $1,350,000.00 as a capital non-taxable payment to the wife pursuant to the rollover provisions of the Act or will Revenue Canada, Taxation take the position that the extra $350,000.00 is really interest which should be taxable in the hands of. the wife?  Will Revenue Canada, Taxation take the position that the husband and wife have concocted a scheme to evade tax by amortizing the interest into principal and treating it as capital?

Subsection 16(1) of the Act deals with payments that are often referred to as "blended payments", the make-up of which are not definitely ascertainable but can reasonably be regarded as being partly of a capital nature and partly of an income nature.  Where a blended payment is received by a taxpayer in a particular taxation year, any income element that can be characterized as interest must, by virtue of  paragraph 16(1)(a), be included in computing income for that year, unless otherwise included elsewhere.

Interest, while not defined in the Act, has been described in general terms by the courts as "the return or consideration or compensation for the use or retention by one person of sum of money, belonging to, in a colloquial sense, or owed to, another". Based on the facts as you have described them, it is clear that the extra $350,000.00 represents compensation to the wife from the husband for his inability to immediately pay her the amount to which she was originally immediately entitled.

However, it is also the position of Revenue Canada, Taxation that where property of any kind is sold on a deferred or instalment payment basis and no interest is specified in the contract (other than in respect of arrears), it will not necessarily be presumed that there is an interest or other income element in each payment.  It is possible to impute interest under paragraph 16(1)(a) only in a case where it can be shown conclusively that the selling price of the property was greater than its fair market value.  Where this can be done, the amount of interest so imputed will not be considered to be greater than the lesser of the excess of the selling price over the market value and an amount computed with reference to the interest prevailing in the locality for that type of transaction.  Therefore, in order to determine conclusively whether any interest income will be deemed to be received by the wife under paragraph 16(1)(a), the fair market value of the shares must be ascertained.

We trust the above is of assistance to you.  We have enclosed a copy of Interpretation Bulletin IT-265R2 on this subject.

Yours truly,

for DirectorBusiness and General DivisionSpecialty Rulings DirectorateLegislative and Intergovernmental Affairs Branch