8 November 1989 Income Tax Severed Letter AC81222 - Continuation of "Reasonableness of Transaction" Test in Inter-corporate Loss Utilization Schemes

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.

8122-2
Bilingual Services (Specialty)               Alain Godin         

Nov. 8, 1989

ISSUE

Whether we should continue to apply a "reasonableness of transaction" test in inter-corporate loss utilization schemes.

SECTION 20(1)(c)

Subject

Paragraph 20(1)(c) allows a deduction for interest on money borrowed for the purpose earning income from a business or property. In certain loss utilization arrangements similar to that in 14 , (i.e. those done without doing a winding-up or an amalgamation), money is borrowed and the question arises as to whether a favourable paragraph 20(1)(c) ruling should be given. Prior practice consisted of granting favourable 20(1)(c) rulings if the requirements of our reasonableness test (described below) were satisfied. Considering clause 2 of the Notice of Ways and Means Motion of September 29, 1988 the Notice), is the reasonableness test still applicable and should opinions in respect of the Notice be given? If not, under what conditions should we grant favourable 20(1)(c) rulings?

Background

In a typical tax consolidation scheme, a profitable corporation (profitco) borrows money (from a related unprofitable corporation (Lossco)) and invests the borrowed money in preferred shares. The transactions often involve large amounts of borrowed money and large investments in shares over relatively short periods of time. They also involve daylight loans from arm's length parties or preferred share investments made in consideration of a promissory note where the Jurisdiction permits (province of Quebec). After the losses have been absorbed, the shares are redeemed and the loan repaid.

Position

Further to discussions with the Department of Finance, the Review Committee's decision was to continue with the current practice of administering a reasonableness test on a case by case basis. Opinions in respect of the September 29, 1988, Notice of Ways and Means Motion will not be given in dealing with such arrangements, since the purpose of the Notice was to confirm an established practice of Revenue Canada and not to broaden that practice. Therefore, the Notice is not to be read as if it were a statute but rather is to be read in the context of the following position.

The Review Committee's position has generally been to deal with every request on a case-by case basis; however, favourable rulings in respect of paragraph 20(1)(c) should be given only if both the following conditions are met:

a) the shares are cumulative; and

b) the transactions are reasonable.

The reasonableness test in b) above is not only related to the "reasonability of interest amount" test in paragraph 20(1)(c). Rather, it has to do with-the reasonableness of the overall transactions. The purpose of the reasonableness test is to ensure compliance with the income-earning purpose requirement of paragraph 20(1)(c). If the investment is not commercially reasonable, the transaction cannot be considered to have an income earning purpose even if there is a potential for realizing a nominal profit on the transaction. For example, there can be no income-earning purpose if Profitco borrows money at 10% to invest in 11% preferred shares of a Lossco subsidiary that has no profit expectation and no cash flow with which to pay dividends prior to the receipt of interest income from Profitco. This is especially so if the amount borrowed is out of proportion with Profitco's financial situation and if the shares are to be redeemed shortly thereafter. The only purpose for borrowing money in such a transaction is loss utilization. The reasonableness test thus ensures that rulings will be granted only if there exists some commercial normalcy to the investments, amounts borrowed and time frames involved in the transactions.

The following guidelines are also generally considered applicable in evaluating such ruling requests. 1. The amount of the preferred shares should be reasonable in the circumstances. There are no hard and fast rules to abide by provided the reasonableness test is satisfied.

2. If short-term loans are obtained from an arm's length party, the amount of money borrowed should be commensurate with the borrower's normal ability to borrow from an arm's length party for funds that would be used in the borrower's business.

3. Back-to-back arrangements (shares issued in consideration of a promissory note) may be allowed if legally permissible. However, the interest income on the note should generally not be considered in determining the issuing corporation's capacity to pay dividends on its shares.

4. There should generally be some expectation of profit in Lossco (ignoring income arising from the tax consolidation scheme), though not necessarily in the current year, i.e. Lossco should be a going-concern.

5. Rulings need not be restricted to transactions involving the utilization of a corporation's current-year losses against the net income of another corporation prior-year losses can also be offset,

6. If the share being issued is a preferred share, it should be cumulative and have a dividend rate above the borrowing rate in order to satisfy the profit requirement of paragraph 20(1)(c). If the share is a common share, the presumption that the money borrowed therefor is being used by Profitco to earn income may apply, but can usually be rebutted more easily in a non-arm's length situation. Accordingly, taxpayers should be required to invest in cumulative preferred shares of Lossco instead of common shares as part of such arrangements, unless the issuance of common shares can be justified.

7. Paper transactions should not be accepted. In other words, transactions should be fully carried out and be legally effective.

8. Financial capacity generally refers to the cash flow of the issuing corporation, i.e. its net accounting income before depreciation. However, cash flow of a corporation excludes any income of an affiliate that would be included in accordance with the equity method of accounting where the corporation has a significant influence in the affiliate. Such unrealized income of a corporation can be considered in determining the cash flow of another corporation if that corporation is a wholly-owned subsidiary. Cash flow projections should include dividends that will actually be received from an affiliate. It does not include capacity to pay that is attributable to other factors such as cash flow guarantees.