5 December 2002 Internal T.I. 2002-0155667 F - DEDUCTIBILITE DES INTERETS CAPITALISEES
Principal Issue: [TaxInterpretations translation] Is interest payable and capitalized on a loan incurred to acquire common shares deductible pursuant to paragraph 20(1)(c) of the Income Tax Act?
Position: Yes, if the individual regularly uses the accrual method to deduct those expenses in computing income from property in respect of shares and this is the method required under generally accepted principles.
Reasons: Ludco Entreprises Ltd. v. The Queen; Russell Plawiuk v. The Queen, 94 DTC 1050 and text of the Act.
December 5, 2002
Shawinigan-Sud Tax Centre Headquarters
Income Tax Rulings Directorate
Attention: Mr. Robert Villemure
Michelle Desrosiers
Notary, M. Fisc.2002-015566
Deductibility of capitalized interest on a loan to acquire common shares
This is further to your faxes of August 6, 2002 and October 18, 2002, in which you asked for our opinion on the deductibility of capitalized interest on a loan incurred to acquire common shares, i.e., shares whose holder is not precluded, on the redemption of the capital stock, from participating in the assets of the corporation beyond the amount paid for those shares.
The facts as we understand them are as follows:
1. The taxpayer is employed by a Canadian-controlled private corporation (the corporation).
2. In XXXXXXXXXX, the corporation lent the taxpayer $XXXXXXXXXX. This loan bears interest at an annual rate of XXXXXXXXXX%. Interest is calculated and payable annually on XXXXXXXXXX of each year.
3. Any interest not paid when due bears interest at XXXXXXXXXX%.
4. The loan has a term of XXXXXXXXXX years.
5. The loan agreement between the corporation and the taxpayer stipulates that the loan is being made by the corporation to the taxpayer exclusively for the purpose of enabling the taxpayer to pay the subscription price for XXXXXXXXXX participating shares of the capital stock of the corporation to be issued in the name of the borrower under a subscription agreement dated the same day as the loan agreement.
6. The loan agreement also states that the loan is advanced upon issuance of the participating shares of the corporation to the taxpayer.
7. In the years following receipt of the loan and shares, the employee paid no interest on the amounts owing. Instead, interest 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.
8. The employee still owns the shares acquired with the loan.
9. The corporation's latest financial statements show negative retained earnings.
Your Questions
You wish to know if the taxpayer can deduct, pursuant to paragraph 20(1)(c) of the Income Tax Act (the "Act"), the capitalized interest on the loan in the XXXXXXXXXX and subsequent taxation years.
You also wish to know the tax treatment applicable if the taxpayer does not repay the loan when due and the interest on the loan has otherwise been deducted.
Our Comments
Subparagraph 20(1)(c)(i) allows for the deductibility, in computing a taxpayer's income, of interest paid or payable in satisfaction of a legal obligation to pay interest on money borrowed and used to earn income from a business or property.
Prior to the recent 2001 Supreme Court of Canada decisions dealing with interest deductibility, the Agency's long-standing position on the issue of interest deductibility on a loan to acquire common shares was stated in Question 39 of the 1981 Canadian Tax Foundation Conference Round Table as follows: [TaxInterpretations translation]
"It is the Department's opinion that, in general, interest on money borrowed to acquire common shares is deductible on the basis that the potential return to the shareholder may exceed the borrowing cost. It may be determined in particular situations that it is not reasonable to expect a potential return that exceeds the borrowing costs associated with those shares. We have no guidelines for identifying such situations, and are of the view that each situation must be analyzed on its own merits."
Following Ludco Entreprises Ltd. v. The Queen, 2001 DTC 5518, our position as expressed in 2002 at the Association de planification fiscale et financière conference, is now as follows: [TaxInterpretations translation]:
"Normally, we consider interest expense in respect of money borrowed to acquire common shares to be deductible. This position is based on there being, at the time the shares are acquired, a reasonable expectation of the shareholder receiving dividends. However, in certain situations, the expectation of income may not be present.
Where a corporation’s governing documents indicate that dividends are not expected and that shareholders must sell their shares to realize gain on the shares, the purpose test will probably not be met. Where a company has no formal dividend policy, or has a policy of paying dividends when operations permit, the purpose test will likely be met. However, each situation must be examined on its own facts."
Based on the facts of this case, we have assumed that, at the time of the loan, the taxpayer had a reasonable expectation of receiving dividends. For greater certainty, however, this determination is a question of fact that triggers the obligation to establish whether the taxpayer had, at the time the shares were acquired, the expectation of receiving dividends. You must therefore determine whether, at the time the shares were acquired, the taxpayer had the expectation of receiving dividends.
For the purposes of paragraph 20(1)(c), for interest to be deductible in a taxation year, it must be paid in the year, or payable in respect of the year, depending upon the method regularly used by the taxpayer in computing income.
In J.L. Guay Ltée v. M.N.R., 71 DTC 5423 (affirmed 1975), it was established that an amount payable means an absolute and unconditional obligation to pay, even though the amount may not be immediately due. Based on this case, we are of the view that, in the situation described, the interest accrued on the principal of the debt over the years in question constitutes interest payable in respect of those years.
Following Russell Plawiuk v. The Queen, 94 DTC 1050, the Agency's position is to allow an individual to deduct, pursuant to the provisions of paragraph 20(1)(c), interest accrued and payable, to the extent that the individual regularly uses the accrual method to deduct expenses in computing income from property in respect of shares and that this is the method required under generally accepted accounting principles.
Capitalized interest on the borrowed amount could therefore be deducted by the taxpayer if the above conditions are met. However, interest on capitalized interest will be deductible only in the year of payment, under the provisions of paragraph 20(1)(d).
In the present situation, the loan constitutes a commercial debt within the meaning of subsection 80(1). However, should the loan be settled, the forgiven amount will constitute a taxable benefit to the taxpayer in accordance with the provisions of paragraph 6(1)(a) and subsections 6(15) and 6(15.1). Those provisions would apply if the loan was granted to the taxpayer as an employee. On the other hand, if the loan was instead made to the taxpayer as a shareholder and the loan is settled, the forgiven amount will constitute a taxable benefit to the shareholder pursuant to subsections 15(1.2) and 15(1.21) in the year in which the loan is settled. However, the provisions of paragraph 80.4(3)(b) would not apply to reduce any benefit included in the taxpayer's income under section 80.4 in a prior year in respect of such a loan, since no portion of the loan would have been included in income and the taxpayer would have benefited from the use of the funds in those years. See paragraph 11 of Interpretation Bulletin IT-421R2 Benefits to individuals, corporations and shareholders from loans or debts.
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).
Finally, as previously stated, for the purposes of paragraph 20(1)(d), compound interest is deductible only when it is paid. It is our view that paragraph 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.
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 Customs and 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.
Best regards,
Ghislain Martineau
Section Manager
for the Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch