Section 20.1

An individual was required to guarantee a long to a corporation wholly-owned by him and then, three years later, the corporation ceased to carry on business and the individual was required to honour his guarantee, which he did with borrowed money. The Directorate stated:

We will accept that interest on a loan taken to honour a guarantee is deductible under paragraph 20(1)(c) of the Act under the exceptional circumstances principle if the taxpayer can show that the guarantee was given for the purpose of earning income.

After noting that, under the jurisprudence, interest ceased to be deductible when the source of income to, which the borrowing related, disappeared, the Directorate stated:

[W]here a taxpayer borrows money to honour a guarantee in respect of a loan from a corporation of which the taxpayer is the sole shareholder and the interest on that loan would otherwise be deductible under the exceptional circumstances principle, it is our view that subsection 20.1(1) of the Act will apply to allow a deduction for the portion of the interest that is equivalent to the impairment loss on the debt acquired by the guarantor when the source of income to which the interest relates (the shares) no longer exists.

An interest-free loan is made to a corporation which, two years’ later, becomes bankrupt. After noting that under its application of the exceptional circumstances test, it will generally accept the deduction of interest on borrowed money that is used to make an interest-free loan to a wholly-owned corporation (or, if there are multiple shareholders, where each shareholder makes an interest-free loan in proportion to their shareholding) where the funds will be used by the corporation to earn income, thereby increasing the potential for receiving dividends, CCRA then indicated:

[W]here a taxpayer borrowed money to make an interest-free loan to a corporation and the interest on that loan was deductible under the exceptional circumstances principle, we are of the view that subsection 20.1(1) could apply to allow the deduction of interest for the portion equivalent to the impairment loss on the interest-free loan where the source of income to which the interest relates no longer exists.

An individual borrowed money in order to honour his guarantee of debts of a small business corporation that he owned and which had become insolvent and ceased operations. CCRA stated:

[T]he conditions for the application of subsection 20.1(1) have not been satisfied since the money borrowed from the third party was not used to earn income from a business or property. In fact, the money was used to repay the loan of the corporation, which had ceased to carry on its business and no longer offered any reasonable expectation of profit to its shareholders.

Where a partnership is dissolved and the partners receive real property from the partnership in satisfaction of their partnership interests, and the adjusted cost base of the partnership interests at the date of dissolution of the partnership and the fair market value of the property received in satisfaction of the partnership interests is less than the original cost of the partnership interests, the decrease in the adjusted cost base of the partnership interests would not be considered to be lost because of a decline in value of property for purposes of s. 20.1 if such decrease is attributable to drawdowns by the partners of capital from the partnership, given that the borrowed money used initially to acquire the partnership interests thus would be traceable to an ineligible use. If the decrease in the adjusted cost base of the partnership interests is a result of losses of the partnership, the amount of borrowed money used to acquire the consideration for purposes of s. 20.1(1)(b)(i) would be based on the fair market value the property received in satisfaction of the partnership interests and the original cost of the partnership interests.

Interest paid by an individual on a loan made to honour a guarantee made by the individual of borrowings made by a Canadian-controlled private corporation would not be deductible under s. 20.1 because the money borrowed by the individual to honour his guarantee would not be borrowed to be used to earn income from a business or from property given that the corporation was insolvent at the time and had ceased to carry on business. Similarly, if the individual makes interest payments on the corporate loan, such interest would not be deductible because the individual making the payments has not used the borrowed money.

"Where an amount is deemed by virtue of section 80.5 of the Act, to be interest paid in respect of the year pursuant to a legal obligation to pay interest on borrowed money for purposes of paragraph 20(1)(c) of the Act, and the source of income subsequently disappears, and the loan is refinanced, subsections 20(3) and section 20.1 of the Act should be applicable. Consequently ... the deemed interest on the portion of the borrowed money that has been lost should be deductible."