An employee of a CCPC was lent money by the corporation to acquire common shares of the corporation. In the years thereafter, the employee paid no interest on the loan and the interest instead was capitalized on the loan. The employee, still holding the shares, deducted the interest payable under the terms of the loan in computing the individual’s income.
After finding that the employee could deduct simple interest on the loan notwithstanding it being capitalized (but not compound interest, which would not be deductible until paid) on the assumption that there was a reasonable expectation of receiving dividends on the shares, and noting that a taxable benefit would arise if the loan was forgiven, the Directorate went on to state:
In addition, capitalized interest that is forgiven when the loan is written off will also have to be included in the taxpayer's income. Pursuant to paragraph 80(2)(b), the principal amount of interest payable by a debtor is the portion of the interest that is deductible or would have been deductible but for subsections 18(2) or (3.1) or section 21. According to that paragraph, the amount of that interest also constitutes a debt issued by the debtor for the same amount. Consequently, after reducing its tax accounts, if any, by the application of subsections 80(3) to 80(12), the taxpayer will be required to include in computing its income the result determined under subsection 80(13), in accordance with the provisions of paragraph 12(1)(z.3).
…[C]ompound interest is deductible only when it is paid. …[P]aragraph 80(2)(b) will not apply to compound interest if it is not deductible by virtue of paragraph 20(1)(d), being considered unpaid. Consequently, the provisions of section 80 will not apply to the forgiveness of the amount of accrued compound interest.