17 December 1992 Income Tax Severed Letter 9236257 - Interest Deductibility

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.

December 17, 1992

Vancouver District Office Head Office
Technical Business Enquiries Rulings Directorate
Financial Industries
Attention: T.C. Fitz-Clark
Division
Michael Cooke
(613) 957-8972

923625

Interest Deductibility on Preferred Shares

We are writing in response to your fax of December 2, 1992, in which you requested our comments on the deductibility of interest expense as it pertains to a particular taxpayer's fact situation, as outlined in their letter to you dated November 24, 1992, based on current income tax legislation.

These questions deal with specific fact situations and primarily concern a determination of whether the purpose test, of paragraph 20(1)(c) of the Act, is met where borrowed funds are used to make preferred share investments. However, such a determination can only be made after a complete review of all relevant facts and circumstances surrounding the borrowing, and accordingly, we can only offer our general comments as follows:

As stated in our response to question 11 of the Canadian Tax Foundation's 1990 Round Table, the Department will normally permit a deduction for the full interest expense incurred when a taxpayer borrows money at interest to acquire preference shares of a company where all four conditions are satisfied:

• 1. The purchaser of the preferred shares may reasonably be considered to enjoy all the rights and privileges attached to the ownership of a majority of all the classes of shares of the issuing corporation through direct or indirect ownership of such shares.
• 2. The proceeds of the share issue are used by that corporation in its own operation to produce income from a business or property that will be subject to Part I tax in Canada, or are used by that corporation to loan to its Canadian subsidiary (IT-445 paragraphs 6 & 7) at less than a reasonable rate of interest (or at no interest), to be used in its operations to produce income from a business or property subject to Part I tax in Canada.
• 3. The corporation has made every effort to obtain the necessary funds through the usual commercial money markets but cannot obtain financing, without the guarantee of the shareholder, at competitive interest rates at which the shareholder could borrow.
• 4. The arrangement does not result in any undue tax advantage. Examples of situations in which an undue tax advantage would be found to exist are listed in paragraph 8 of IT-445 and include arrangements that result in the circumvention of the capital cost allowance restrictions in respect to leasing and rental property or the shifting of income to provinces with lower tax rates.

Notwithstanding the above, in situations where preferred shares can be converted to common shares, and the right of conversion is free and unrestricted, any interest expense incurred to acquire such preferred shares would normally be fully deductible, subject to our comments on the deductibility of interest expense incurred on the purchase of common shares below. However, where the convertible shares are owned by a shareholder who is not dealing at arm's length with the corporation, the deductibility of interest can only be determined from the facts of the specific case.

Normally, the Department considers interest costs, in respect of funds borrowed to purchase common shares, to be fully deductible on the basis that the potential return to the common shareholder may exceed his borrowing cost. It is conceivable that, in certain fact situations, it would be unreasonable to expect a potential return in excess of the borrowing costs related to such shares. We do not have any guidelines that might be used to isolate such situations, and each situation must be dealt with on the basis of all the facts involved.

Where the directors have the ability to declare dividends on a class of shares, to the exclusion of other classes of shares, on a discretionary basis, this will be a very important factor in determining whether the purpose test of paragraph 20(1)(c) of the Act is met. In situations where shares are issued, but the purpose test is not met, the Department will generally permit a deduction for interest expense but only to the extent of dividend income for the year.

for Director
Financial Industries Division
Rulings Directorate