Principal Issues: [TaxInterpretations translation] Is interest on amounts owed to shareholders of a corporation deductible from the corporation's income?
Position: no
Reasons: The conditions of paragraph 20(1)(c) are not satisfied.
March 3, 2006
Quebec Tax Services Office Headquarters
Technical advisors Income Tax Rulings Directorate
Attention: Mr. Roch Méthot Michel Lambert
(613) 957-89532005-015187
XXXXXXXXXX
This is further to the September 20, 2005 memorandum we received regarding the above taxpayer. You wish to know whether interest on amounts owed by the taxpayer to its shareholders is deductible in computing its income pursuant to paragraph 20(1)(c).
Unless otherwise indicated, all statutory references herein are to provisions of the Income Tax Act (the "Act").
Designation of parties
XXXXXXXXXX Shareholder A
XXXXXXXXXX Shareholder B
XXXXXXXXXX Shareholder C
XXXXXXXXXX Taxpayer
Summary of the Facts
1. Shareholder A, Shareholder B and Shareholder C are the three shareholders of the Taxpayer.
2. The Taxpayer's retained earnings as of XXXXXXXXXX were approximately $XXXXXXXXXX.
3. On XXXXXXXXXX, the Taxpayer declared a dividend of $XXXXXXXXXX.
4. On XXXXXXXXXX, the Taxpayer paid the declared dividend by issuing to each shareholder an interest-free Note in the amount of $XXXXXXXXXX (the "Initial Note or collectively the "Original Notes")
5. On XXXXXXXXXX, the Taxpayer refinanced each Note owed by Taxpayer to each Shareholder with a Note in the same amount bearing interest at the prime rate of XXXXXXXXXX. Each Note was executed on XXXXXXXXXX retroactive to XXXXXXXXXX
6. During the years XXXXXXXXXX, there were other dividends declared and paid in the same manner as set forth above.
7. The Taxpayer deducted from its income interest on amounts due to its shareholders in the following amounts:
in XXXXXXXXXX: $XXXXXXXXXX
in XXXXXXXXXX $XXXXXXXXXX
in XXXXXXXXXX $XXXXXXXXXX
Your Opinion
8. The annual interest expense is not deductible under paragraph 20(1)(c). The Original Notes were used to pay dividends. This is not an eligible use for which an interest deduction can be claimed. The new debt must receive the same tax treatment.
Taxpayer's Opinion
9. The Taxpayer's Representative disagrees with the facts set forth in Items 5 and 6. According to the representative, on XXXXXXXXXX the Taxpayer made a borrowing of $XXXXXXXXXX from each shareholder by forgiving debt in an equivalent amount that was owed to the shareholders under the Original Notes, which were acknowledged to be cancelled by the shareholders. Those new loans bear interest and are secured by a moveable hypothec. No Notes were issued at that time. It is therefore a true loan. The Original Notes were not "refinanced" by other Notes but cancelled since they were paid out of the new loan.
10. The Corporation issued new Notes on XXXXXXXXXX retroactive to XXXXXXXXXX. They did not replace the Original Notes issued on XXXXXXXXXX and cancelled as of XXXXXXXXXX. The new Notes were only intended to recognize the XXXXXXXXXX loans as there is no mention of those Notes replacing or canceling the loans. That transaction was effected at the request of a financial institution.
11. It is the opinion of the Taxpayer's representative that the interest on the XXXXXXXXXX loan is deductible from the Taxpayer's income pursuant to paragraph 20(1)(c).
12. The situation is similar for each year in question.
Our Opinion
13. We have reviewed all documentation provided to us by the Taxpayer's representative in order to determine whether the interest in question is deductible from the Taxpayer's income. After considering the documentation provided, we cannot accept the claims of the Taxpayer and its representatives.
14. Paragraph 20(1)(c) permits the deduction of interest where all the conditions set out therein are satisfied. In particular, the amount must be paid or payable in satisfaction of an obligation to pay interest on borrowed money used for the purpose of earning income from a business or property [20(1)(c)(i)] or on an amount payable for property acquired for the purpose of gaining or producing income from a business [20(1)(c)(ii)].
15. Each Initial Note does not constitute an amount payable for property acquired as it was issued upon the payment of dividends, which is not an acquisition of property.
16. Subparagraph 20(1)(c)(i) requires that the interest deducted be in respect of "borrowed money used for the purpose of earning income from a business or property". In Bronfman Trust v. Canada, 1987 DTC 5059 (SCC), the court stated that “[t]he statutory deduction thus requires a characterization of the use of borrowed money as… eligible use” and that “[t]he onus is on the taxpayer to trace the borrowed funds to an identifiable use which triggers the deduction.” In Shell Canada Limited v. Canada, 1999 DTC 5669 (SCC), the court stated that "[i]nterest is deductible only if there is a sufficiently direct link between the borrowed money and the current eligible use”. In Singleton v. Canada, 2001 DTC 5533 (SCC), the court stated: "It is now plain from the reasoning in Shell that the issue to be determined is the direct use to which the borrowed funds were put.” Consequently, we are of the view that the applicable test is the direct use of the borrowed money.
17. In addition, subparagraph 20(1)(c)(i) only permits a deduction for interest if money was borrowed. If we accept as correct the argument of the Taxpayer's representative that the amounts owing to the shareholders constitute borrowed money, it is our view that the borrowed money was used to replace the Original Notes issued in payment of the dividends, which is not an eligible use unless subsection 20(3) applies. Since the Taxpayer did not acquire any property when the Note was issued, paragraph 20(3)(b) does not apply in this case. Therefore, the interest would not be deductible from the Taxpayer's income under subparagraph 20(1)(c)(i).
18. If we consider that the amounts owing to the shareholders are not borrowed money, we are of the view that they would be an amount payable, issued to replace the Original Notes, which were not issued to acquire property. The interest would therefore not be deductible under subparagraph 20(1)(c)(ii).
Access to Information
For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, the electronic library version can be provided. Alternatively, the client may request a severed copy using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Ms. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.
We hope that these comments are of assistance.
Manager
Financial Sector and Exempt Entities Section
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch