The common shares of XY Inc. (with an active business) are held equally by the two holding companies for X and Y (namely, X Inc. and Y Inc.), and X and Y each holds a preferred share (or, alternatively, a common share) of XY Inc. directly. Would interest on bank loans used by X Inc. and Y Inc. to make equal (or unequal) non-interest bearing loans to XY Inc. be deductible? After referencing the general principle that “interest expense on borrowed money used to make an interest-free loan … may be deductible … where the facts disclose that the money was borrowed for an indirect current use whose purpose was the earning of income from a business or property,” CRA stated:
The CRA generally agrees that this is the case where, firstly, the interest-free loan affects the corporation's capacity to earn income and, furthermore, the interest-free loan is granted to a corporation by its sole shareholder or, if there are several shareholders, each shareholder has granted an interest-free loan to the corporation in proportion to the shareholder’s interest in the corporation.
In other situations, the taxpayer must demonstrate that making an interest-free loan to a corporation affects the taxpayer's income-earning capacity and, therefore, that there is a sufficient link between the interest-free loan and a source of the taxpayer's income. In this regard, the principles followed in … Canadian Helicopters … could be useful.