Principal Issues: [TaxInterpretations translation] Is interest paid on a loan made by an operating corporation deductible in circumstances where the loan was used to make an interest-free loan to another corporation for the latter to acquire the shares of the operating corporation?
Position: No
Reasons: According to the facts submitted, the borrowed money is not used directly or indirectly to earn income.
2008-029763 XXXXXXXXXX Catherine Ayotte, Notary, M. Fisc. November 25, 2008
Dear Sir,
Subject: Deductibility of interest in a corporation
This is further to your email of October 22, 2008, in which you asked our opinion on the above subject. More specifically, you wish to know if the interest paid in the following situation is deductible: an operating corporation borrows money to make an interest-free loan to another corporation so that the latter can acquire the shares of the operating corporation.
Please note that unless otherwise indicated, all legislative references herein are to the provisions of the Income Tax Act (the "Act").
It appears to us that the situation described in your letter could constitute an actual situation involving taxpayers. As explained in Information Circular 70-6R5, it is not the Directorate’s practice to comment on proposed transactions involving specific taxpayers otherwise than in the form of an advance income tax ruling. If your situation involves a specific taxpayer and a completed transaction, you should provide all relevant facts and documents to the appropriate Tax Services Office for its views. We are, however, prepared to provide the following general comments that may be of assistance to you.
Interpretation Bulletin IT-533 Interest Deductibility and Related Issues1 sets out the Canada Revenue Agency's position on the deductibility of interest in light of court decisions on this issue.
Subparagraph 20(1)(c)(i) requires that the interest deducted relates to money borrowed used for the purpose of earning income from a business or property. In order to determine the purpose for which the borrowed money was used, the courts have applied the test of the direct use of borrowed money. However, in certain exceptional circumstances, the courts have accepted that the test that prevails is that of the indirect use of the borrowed money. Paragraphs 22 to 26 of IT-533 describe exceptions to direct use.
The interest expense on money borrowed and used to make an interest-free loan is generally not deductible since the loan is used directly to acquire property that cannot generate income. However, where it can be shown that the direct use can nevertheless affect the taxpayer's ability to earn income, the interest could be deductible.
Based on the facts you have submitted to us, the circumstances do not allow us to conclude that the interest-free loan granted by the operating corporation allows it to earn income.
We hope that our comments are of assistance.
Best regards,
Ghislain Martineau
Manager
Financial Sector and Exempt Entities Section
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch.
ENDNOTES
1 Available on the CRA website at http://www.cra-arc.gc.ca/E/pub/tp/it533.