Principal Issues: Whether interest is deductible in various fact situations where shareholders borrow money (at interest) and loan money interest-free to a corporation in which the shareholders own shares.
Position: General comments. Reference to paragraph 1.54 of Folio S3-F6-C1 Interest Deductibility.
Reasons: Question of fact
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XXXXXXXXXX 2017-071214 Sylvie Labarre, CPA, CA November 3, 2017
Dear Sir,
Subject: Interest Deductibility
This is in response to your e-mail of June 28, 2017 in which you requested our position regarding the deductibility of interest in the following hypothetical situation.
Unless otherwise indicated, all statutory references herein are to provisions of the Income Tax Act (the "Act").
Hypothetical Situation
1. The shares of the capital stock of XY Inc. were held as follows:
X Inc.: 50 % of the common shares;
Y Inc.: 50 % of the common shares;
X: 1 class A preferred share; and
Y: 1 class A preferred share.
2. X held all of the common shares of the capital stock of X Inc.
3. Y held all of the common shares of the capital stock of Y Inc.
4. XY Inc. was a corporation actively carrying on a business.
5. X Inc. and Y Inc. each borrowed $100,000 from a Canadian bank. The loans bore interest at 4% per annum.
The two corporations then lent the loan proceeds to XY Inc. without interest. The purpose of the loans was to provide XY Inc. with financing to carry out the operations necessary to its business.
Questions
1. You wish to know if the total of the interest paid by X Inc. and Y Inc. would be deductible in computing their income, taking into account that X and Y personally held shares in the capital stock of XY Inc.
2. You asked if our answer would be the same if X and Y held common shares in the capital stock of XY Inc. rather than preferred shares.
3. You also asked if our answer would be the same if the respective amounts of the borrowings by X Inc. and Y Inc. and their interest-free loans made to XY Inc. instead were $100,000 for X Inc. and $200,000 for Y Inc.
Our Comments
This technical interpretation provides general comments about the provisions of the Act and related legislation, where referenced. It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of particular transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R7, Advance Income Tax Rulings and Technical Interpretations.
In general, subparagraph 20(1)(c)(i) allows the deductibility of an amount paid in the year or payable in respect of the year (depending on the method regularly followed by the taxpayer in computing the taxpayer’s income), pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from a business or property.
As provided in para. 1.54 of Folio S3-F6-C1 Interest Deductibility, interest expense on borrowed money used to make an interest-free loan is not generally deductible since the direct use is to acquire a property that cannot generate any income. However, interest may be deductible under the exceptional circumstances principle 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. The taxpayer must demonstrate that the direct use can nonetheless have an effect on the taxpayer's income-earning capacity.
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 the decision of the Federal Court of Appeal in The Queen v. Canadian Helicopters Ltd. (2002 DTC 6805) could be useful.
That said, it is a question of fact that can only be answered after an exhaustive analysis of all the facts in a given file. To that end, all the relevant elements in a given situation should be examined to see whether there are exceptional circumstances, and any new clarification provided by the courts in this context should also be considered.
Furthermore, in certain circumstances, it would also be necessary to consider whether other legislative provisions could apply, for example, in a case where certain shareholders grant interest-free loans to a corporation in different proportions to their shareholdings. We do not comment on this subject in this letter.
The above comments are applicable to your three questions.
We hope that our comments are of assistance.
Best regards,
Urszula Chalupa, LL.B, M. Fisc.
for the Director
Reorganizations Division
Income Tax Rulings Directorate
Legislative Policy
and Regulatory Affairs Branch