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.
Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.
Principal Issues:
The deductibility of interest on borrowed money used to acquire preferred shares which were exchanged for common shares of a related company, three months after their acquisition.
Position TAKEN:
Interest on preferred shares may be deductible if rate of dividend greater than rate of interest.
Interest on common shares may not be deductible.
Reasons FOR POSITION TAKEN:
Question of facts - Shares must be acquired to earn income.
June 3, 1994
EDMONTON DISTRICT OFFICE HEAD OFFICE
Audit Division Rulings Directorate
Attention: Mohamed Shariff A. St-Amour
(613) 957-8953
7-940542
Deductibility of interest under 20(1)(c) of the Income Tax Act
This is in response to your memoranda of February 28 and April 22, 1994, requesting our opinion on the deductibility of interest for 1989, 1990 and 1991 on a loan used originally to purchase preferred shares. In this memorandum, all references to statute are to the Income Tax Act S.C. 1970-71-72, c. 63 as amended consolidated to June 10, 1993 (the "Act").
The facts as submitted are as follows:
XXXXXXXXXX
District Office Position
In your analysis, you only considered that the Loan was used to purchase the preferred shares of XXXXXXXXXX. The tax consequences of the change of use were not addressed. You are of the view that the interest on the loan is not deductible since it does not meet the Department's position stated in the response to Question 11 of the Canadian Tax Foundation's 1990 Round Table.
Taxpayer Position
The taxpayer's representative alleges that the interest on the Loan is deductible for the following reasons:
-XXXXXXXXXX had enough cash to finance the purchase of the Preferred Shares. The cash was used to purchase the shares, while the Loan was used as working capital.
-The preferred shares were purchased to earn income in accordance with paragraphs 18(1)(a) and 20(1)(c)(i) of the Act and are not "exempt income" as defined in paragraph 248(1) of the Act.
-The preferred shares participate in Dividends with common shares and would participate with common shares for distribution of proceeds on liquidation.
-The interest in not being deducted by the corporation which invested the funds in a non-resident corporation.
Our Position
The deduction of interest is based on a purpose test that looks not to the motivation for the borrowing, but rather to the purpose of the use to which the borrowed funds are put. In The Queen v. Bronfman Trust 87 DTC 5059 (SCC), Judge Dickson stated that it was the current use rather than the original use of borrowed funds by a taxpayer which was relevant in assessing the deductibility of interest payment. Thus, deductibility depends on the use of the funds in the current year. This evaluation has to be made on a yearly basis.
It is the Department's general view, as stated in Question 20 of the 1987 Corporate Management Tax Conference and Questions 54 and 18 of the 1987 and 1984 Revenue Canada Round Tables, that where one income source is disposed of and the proceeds are used to acquire another income source, interest on the borrowed money that was used to acquire the first source will continue to be deductible to the extent that the amount of borrowed money does not exceed the value of the new income source. Alternatively, in the Bronfman Trust case, in the obiter, the Supreme Court stated that a taxpayer who uses or intends to use borrowed money for an ineligible purpose, but later uses the funds to earn non-exempt income from a business or property, ought not to be deprived of the deduction for the current, eligible use. There is however a limit on this principle, when the taxpayer has expended the borrowings on an ineligible use, and has received no enduring benefit or saleable property in return, the borrowed money could obviously not be available to the taxpayer for a subsequent use, whether eligible or ineligible.
1.Preferred Shares
The Department's position on interest expense resulting from a loan used by a corporation to acquire preferred shares is stated in Questions 3 and 11 of the 1980 and 1990 Revenue Canada Round Tables. It mentions that interest expense is only fully deductible if the rate of interest is equal to or less than the rate of return on the preferred shares. However, we are of the view that the interest may not be deductible if the transaction cannot be considered to have an income earning purpose that is if the company that issued the preferred shares has no profit expectation and no cash flow with which to pay dividends.
XXXXXXXXXX
2.Common Shares
The use of funds to acquire common shares, even of a speculative nature, is an eligible use except in unusual circumstances where it is quite unreasonable to expect a potential return in excess of the cost of the borrowing. This position is stated in the 1981 Revenue Canada Round Table Question 39, in Question 24 of the 1987 Corporate Management Tax Conference and the 1988 Revenue Canada Round Table - Position Papers.
Where it is determined that the common shares were not acquired for the purpose of earning income (this is usually the exception to the rule), we are of the view that the purpose test in paragraph 20(1)(c) has not been met and the entire amount of the interest on the borrowings used to purchase those shares will not be deductible.
It is a question of fact whether the purchase of the Common Shares is for the purpose of earning income from a source in Canada. We are unable to confirm whether or not the purchase of the Common Shares is for the purpose of earning income and therefore that interest would be deductible for 1989, 1990 and 1991. The lack of information in this situation does not allow us to make a determination regarding reasonable expectation of profits in XXXXXXXXXX and whether or not there is a potential return on the Common Shares. The fact that
XXXXXXXXXX
Additional facts obtained may include the following:
1) The percentage of ownership by XXXXXXXXXX after the acquisition of the Common Shares.
2) The reasons why XXXXXXXXXX was used for three months to hold the Preferred Shares.
3) The reasons why the Preferred Shares were exchanged for Common Shares of XXXXXXXXXX
4) The terms of the Common Shares should be examined.
5) Any other investments held by XXXXXXXXXX which would generate revenues and would potentially allow XXXXXXXXXX to pay dividends on the Preferred Shares.
6) Any other investments held by XXXXXXXXXX which would have any potential of income.
Furthermore, the value of the Common Shares, at the time they were acquired, needs to be established. Question 54 of the 1987 Revenue Canada Round Table addressed this issue. Monies were borrowed to purchase a share which was disposed of to a corporation in consideration for shares of that corporation pursuant to subsection 85(1) of the Act. The Department stated that the income source was exchanged for a new income source and interest will continue to be deductible to the extent that the amount of borrowed money does not exceed the value of the new share.
3.The taxpayer's representative alleges that XXXXXXXXXX had enough cash to finance the purchase of the Preferred Shares. However, the facts and agreements disclose that the Loan, not the taxpayer's funds, was used to purchase the Preferred Shares. It is not what the taxpayer might have done that determines the issue but the Court must deal with what the taxpayer actually did. This principle was set out in Commissioners of Inland Revenue v. Wesleyan and General Assurance Society (30 T.C. 11) and the Bronfman Trust case.
If you have any further questions do not hesitate to contact us.
for Director
Financial Industries Division
Rulings Directorate
All rights reserved. Permission is granted to electronically copy and to print in hard copy for internal use only. No part of this information may be reproduced, modified, transmitted or redistributed in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, or stored in a retrieval system for any purpose other than noted above (including sales), without prior written permission of Canada Revenue Agency, Ottawa, Ontario K1A 0L5
© Her Majesty the Queen in Right of Canada, 1994
Tous droits réservés. Il est permis de copier sous forme électronique ou d'imprimer pour un usage interne seulement. Toutefois, il est interdit de reproduire, de modifier, de transmettre ou de redistributer de l'information, sous quelque forme ou par quelque moyen que ce soit, de facon électronique, méchanique, photocopies ou autre, ou par stockage dans des systèmes d'extraction ou pour tout usage autre que ceux susmentionnés (incluant pour fin commerciale), sans l'autorisation écrite préalable de l'Agence du revenu du Canada, Ottawa, Ontario K1A 0L5.
© Sa Majesté la Reine du Chef du Canada, 1994
Email this Content