27 March 1998 Ruling 970133A - THIN CAPITALIZATION - BACK-TO-BACK LOANS

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: Administrative position on subsection 18(6).

Position: Please review document

Reasons: Intepretation of position set out in IT Bulletin.

XXXXXXXXXX 						Olli Laurikainen
(613) 957-2116
Attention:  XXXXXXXXXX 

March 27, 1998

Dear Sirs:

Re: Subsections 18(4) and 18(6) of the Income Tax Act (the "Act")

This is further to our technical interpretation letter to you dated March 8, 1996 regarding the application of the above provisions of the Act. The March 8, 1996 technical interpretation set out the following hypothetical situation.

A) A non-resident corporation ("Parentco") owns all the shares of two corporations resident in Canada ("Opco 1" and "Opco 2"). Opco 1 and Opco 2 in turn hold a 51% and a 10% ownership, respectively, in another corporation resident in Canada ("Subco").

B) A non-resident corporation that is related to Parentco ("Sisterco") makes a loan to Opco 2 (the "first loan") on condition that it makes a loan to Subco (the "second loan"). The first loan is not subject to subsection 18(4) of the Act because Opco 2 has sufficient equity computed under subparagraph 18(4)(a)(ii) of the Act.

C) Subco has nominal equity computed under subparagraph 18(4)(a)(ii) of the Act.

Our October 8, 1996 letter set out the following position with respect to the application of subsection 18(6).

Regardless of whether subsection 18(4) of the Act applies or not to deny all or a portion of the interest paid on the "first loan" referred to in subsection 18(6) of the Act, subsection 18(6) will not be applied to the "second loan" referred to in subsection 18(6) of the Act in circumstances where such loan is made by a corporation resident in Canada ("Canco 1") to a second corporation resident in Canada ("Canco 2") provided that:

1. The person who made the "first loan" referred to in that provision is a specified non-resident shareholder of Canco 1 and qualifies as a specified shareholder of Canco 1 otherwise than by virtue of a right referred to in paragraphs (c) or (d) of the definition of specified shareholder in subsection 18(5);

2. The first loan and the second loan bear the same rate of interest; and

3. Canco 1 and Canco 2 are related.

The Department has subsequently withdrawn the above position. Moreover, the Department has concluded that if condition 2) above were satisfied, the result would generally be that a deduction in respect of the interest paid on the first loan could be denied under paragraph 20(1)(c) of the Act on the basis that the borrowed money was not used by Canco 1 to earn income. That is, the interest revenue of Canco 1 on the second loan less the interest expense attributable to the first loan yields no income for Canco 1 and, based on the facts, there is no indication whether Canco 1 is able to benefit in another manner by virtue of having made the second loan.

The Department will nevertheless stand by paragraph 3 of Interpretation Bulletin IT-59R3. In our view, paragraph 3 of IT-59R3 contemplates a case where a non-resident person ("NRP") which has de jure control over a corporation resident in Canada ("C1"), makes a loan ("Loan 1") to C1 and C1 makes a loan ("Loan 2") in the same amount to another corporation resident in Canada ("C2") over which NRP has de jure control. In such a case the Department would not seek to apply the provisions of subsections 18(4) and 18(6) of the Act to interest paid on Loan 2. However, the interest earned on the second loan would generally have to exceed the interest paid on the first loan in order for the interest paid on the first loan to be deductible pursuant to paragraph 20(1)(c) of the Act.

In reference to the hypothetical situation described in paragraphs A) to C) above, we note that paragraph 3 of IT-59R3 would not have application because Sisterco does not have de jure control over Opco 1 and Opco 2. Therefore it is our view that subsection 18(6) of the Act would apply to deem the second loan to be a debt incurred by Subco to Sisterco. The second loan would then be included in Subco's "outstanding debts to specified non-residents" as defined in subsection 18(5) of the Act. Accordingly, since Subco has only nominal equity as computed under subparagraph 18(4)(a)(ii), subsection 18(4) would apply to deny a deduction to Subco in respect of a portion of the interest paid on the second loan.

The foregoing comments are given in accordance with the practice referred to in paragraph 22 of information Circular 70-6R3 and are not binding on Revenue Canada.

Yours truly,

for Director
Reorganizations and International Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch