Principal Issues: Whether interest is deductible in various fact situations where a taxpayer borrows money (at interest) and uses the proceeds of the borrowed money to make an interest-free loan.
Position: General comments. Reference to paragraphs 1.54 and 1.55 of Folio S3-F6-C1 Interest Deductibility.
Reasons: Question of fact. The direct use of proceeds of the borrowed money by the taxpayer must have an effect on the taxpayer’s income-earning capacity.
XXXXXXXXXX 2021-091258 N. Aubin (438) 340-0531
February 10, 2022
Dear Madam,
Subject: Interest deductibility - money borrowed to make an interest-free loan
This is in response to your interpretation request dated September 30, 2021, in which you requested a technical interpretation regarding interest deductibility under the Scenarios contemplated in a particular hypothetical situation ("Particular Situation") described below.
Unless otherwise indicated, all references herein are to the provisions of the Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.) (the "Act").
This technical interpretation provides general comments on provisions contained in the Act and other related legislation. It does not confirm the income tax treatment of a particular situation but is intended to assist you in making that determination. Our Directorate will only confirm the tax treatment of particular transactions in the context of a request for an advance income tax ruling as described in Information Circular IC 70-6R11, Advance Income Tax Rulings and Technical Interpretations.
You described the facts applicable to the Particular Situation as follows:
1. Aco, Bco, Cco, Dco and Eco are corporations incorporated under the Business Corporations Act, R.S.Q., c. S-31.1.
2. The corporations are stacked, specifically:
- Aco holds all the shares of the capital stock of Bco;
- Bco holds all the shares of the capital stock of Cco;
- Cco holds all the shares of the capital stock of Dco;
- Dco holds all the shares of the share capital of Eco.
3. Dco holds 99.9% of the units in several limited partnerships ("LPs") as a limited partner. At the year end of the LPs, 99.9% of the net income of the LPs is allocated to Dco.
4. Eco holds 0.1% of the units in such LPs as general partner. At the year end of the LPs, 0.1% of the net income of the LPs is allocated to Eco.
5. Aco, Bco, Cco, Dco and Eco are "Canadian corporations" as defined in subsection 89(1).
6. Aco, Bco and Cco are not operating companies. They hold investments in other private corporations, which are their subsidiaries.
7. Dco is an operating company.
You described the assumptions for Scenarios 1 through 4 of the Particular Situation as follows:
Scenario 1
- Dco receives an interest-bearing loan from a financial institution;
- Dco makes interest-free loans to the LPs; these are not capital contributions;
- The LPs use the funds borrowed from Dco in carrying on their business.
Scenario 2
- Aco receives an interest-bearing loan from a financial institution;
- Aco makes interest-free loans to the LPs; these are not capital contributions;
- LPs use the funds borrowed from Aco in carrying on their business.
Scenario 3
- Aco receives an interest-bearing loan from a financial institution;
- Aco makes an interest-free loan to Bco;
- Bco makes an interest-free loan to Cco;
- Cco makes an interest-free loan to Dco;
- Dco makes interest-free loans to the LPs; these are not capital contributions;
- The LPs use the funds borrowed from Dco in carrying on their business.
Scenario 4
- Aco receives an interest-bearing loan from a financial institution;
- Aco makes an interest-free loan to Dco;
- Dco makes interest-free loans to the LPs; these are not capital contributions;
- The LPs use the borrowed funds in carrying on their business.
You asked whether, in Scenario 1, Dco can deduct the interest on the loan from the financial institution and whether, in Scenarios 2, 3 and 4, Aco can deduct the interest on the loan from the financial institution.
Our Comments
Generally, subparagraph 20(1)(c)(i) permits the deductibility of interest 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. Under the jurisprudence, the applicable test is generally the direct use of the borrowed money.
Income Tax Folio S3-F6-C1, Interest Deductibility, March 18, 2016 ("Folio S3-F6-C1"), provides exceptions to the direct use of borrowed money test, including in ¶¶ 1.54 and 1.55 of Folio "S3-F6-C1".
In paragraph 1.54 of Folio S3-F6-C1, the CRA states that 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. The CRA also states that where it can be shown that this direct use can nonetheless have an effect on the taxpayer's income-earning capacity, the interest may be deductible.
In paragraph 1.55 of Folio S3-F6-C1, the CRA states that generally, a deduction for interest will be allowed if borrowed money is used to make an interest-free loan to a wholly-owned corporation or in cases of multiple shareholders, where shareholders make an interest-free loan in proportion to their shareholdings and the proceeds of the interest-free loan have an effect on the corporation's income-earning capacity. In other situations, in order for the taxpayer to deduct the interest, the taxpayer must demonstrate that making an interest-free loan to a corporation affects the taxpayer's ability to earn income and, therefore, that there is a sufficient connection between the interest-free loan and a source of income of the taxpayer. In this regard, the principles followed in the Federal Court of Appeal decision in The Queen v. Canadian Helicopters Limited, 2002 FCA 30 ("Canadian Helicopters") may be helpful.
That said, this is a question of fact that can only be answered by a comprehensive analysis of all the facts in a given case. It would be necessary to examine all of the relevant elements in a particular situation to see if there are exceptional circumstances, and it also would be necessary to review any new clarifications made by the courts in that context.
We are, however, prepared to provide the following comments, which may be helpful to you. Our comments are intended only to discuss interest deductibility in the context of Scenarios 1 to 4 of the Particular Situation.
We have assumed that the interest is paid or payable pursuant to a legal obligation to pay interest on the loan and that the amount of interest is reasonable in the circumstances. We also have assumed that each of the corporations involved uses the proceeds of the borrowing or loan to make the interest-free loan in question. In addition, we have assumed that the loans made to the LPs are legally valid under applicable private law.
Scenario 1
We believe that in certain circumstances the comments in paragraphs 1.54 and 1.55 of Folio S3-F6-C1 could apply in the partnership context in a manner similar to that described in the corporate context.
In Scenario 1 of the Particular Situation, under the exceptional circumstances principle, if after a review of all the facts of the situation, it is shown that the loans made by Dco to the LPs affect Dco's ability to earn income from the LPs, the interest on Dco's loan from the financial institution may be deductible to Dco pursuant to subparagraph 20(1)(c)(i), if all other conditions are otherwise satisfied.
Scenarios 2, 3 and 4
In paragraph 1.55 of Folio S3-F6-C1, the CRA explains that a taxpayer who uses borrowed money to make an interest-free loan to its subsidiary may generally deduct the interest on the borrowed money if it can be shown that the proceeds of the interest-free loan will affect the taxpayer's ability to earn dividend income from the subsidiary. In our view, in light of the Federal Court of Appeal's decision in Canadian Helicopters, the fact that the taxpayer's income is derived from dividends from stacked corporations should not be a factor that, in and of itself, prevents a taxpayer from relying on the direct use of borrowed funds exception to make an interest-free loan.
In Scenarios 2, 3 and 4 of the Particular Situation, it would be necessary to assess, in light of all the facts and circumstances of the particular situation, whether the interest-free loans made by Aco to the LP, Bco or Dco, as the case may be, affect Aco's ability to earn income. If so, the interest on Aco's loan from the financial institution may be deductible to Aco pursuant to subparagraph 20(1)(c)(i) on the basis of the exceptional circumstances principle, if all of the conditions are otherwise satisfied. The analysis of this issue must be done on a case-by-case basis, based on the facts and circumstances of each situation.
It should also be noted that the question submitted is essentially intended to obtain the CRA's opinion as to the deductibility of interest in the Particular Situation. Consequently, our comments should not be construed in any way to mean that we have considered the other tax or other consequences that may result from Scenarios 1 through 4 in the Particular Situation.
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