Principal Issues: Is the CRA position in paragraph 31 of Interpretation Bulletin IT-533 still valid after the comments expressed by the court in Swirsky v. The Queen?
Position: Yes.
Reasons: It is a question of fact as to whether a reasonable expectation of income exists.
FINANCIAL STRATEGIES AND INSTRUMENTS ROUNDTABLE, OCTOBER 10, 2014
2014 APFF CONFERENCE
Question 1
Swirsky and the CRA's position in paragraph 31 of IT-533
In paragraph 31 of Interpretation Bulletin IT-533, the Canada Revenue Agency (“CRA”) states in respect of borrowings undertaken to make investments, including the purchase of common shares:
“Where an investment (e.g., interest-bearing instrument or preferred shares) carries a stated interest or dividend rate, the purpose of earning income test will be met “absent a sham or window dressing or similar vitiating circumstances” (Ludco). Further, assuming all of the other requisite tests are met, interest will neither be denied in full nor restricted to the amount of income from the investment where the income does not exceed the interest expense, given the meaning of the term income as discussed in ¶ 10.
Where an investment does not carry a stated interest or dividend rate such as some common shares, the determination of the reasonable expectation of income at the time the investment is made is less clear. Normally, however, the CCRA considers interest costs in respect of funds borrowed to purchase common shares to be deductible on the basis that there is a reasonable expectation, at the time the shares are acquired, that the common shareholder will receive dividends. Nonetheless, each situation must be dealt with on the basis of the particular facts involved.
These comments are also generally applicable to investments in mutual fund trusts and mutual fund corporations.”
However, in Swirsky v. The Queen, 2014 FCA 36, released on February 7, 2014 by the Federal Court of Appeal, the Federal Court of Appeal upheld the original 2013 decision of the Tax Court of Canada. The Court thus denied the deduction of interest to the taxpayer in respect of amounts borrowed from a financial institution to enable Ms. Swirsky to acquire from her spouse common shares of a family SME. In many respects, the transactions resembled in all respects those made in the January 2009 Lipson decision of the Supreme Court of Canada.
However, instead of fully following the findings in the Lipson decision, namely the application of the general anti-avoidance rule to the attribution rule respecting the interest, but with the interest remaining deductible to the spouse, the result was different. The Federal Court of Appeal found that Ms. Swirsky's interest was not deductible because she had no reasonable expectation of profit in connection with the purchase of the corporation’s common shares. In particular, the Court noted that there was no history of payment of dividends, that the corporation paid its shareholders in the form of bonuses and that there was no dividend policy. It was only in 2003, between 8 and 12 years after the shares were acquired, that Ms. Swirsky received her first taxable dividend.
With all due respect to the Court, the reasons for non-deductibility of interest were astonishing in some respects. It is not unusual, far from it, that there are several years before a corporation (SME or very large company) pays dividends to its shareholders, while having an expectation for it to happen one day. In the case of SMEs, this can be for various reasons (lack of profitability in the early years, a necessity for cash reinvestment or simply for tax efficiency considerations). In the case of a very large corporation, it can also take many years before any dividends are paid to shareholders, including sometimes very large sums. The Apple corporation is a glaring example. The Google corporation has not yet started to pay despite high profitability and Google shareholders can hope that it will happen one day, but cannot not put a specific date on it.
Questions to the CRA
a) Can the CRA confirm that its position expressed in paragraph 31 of IT-533 remains the same notwithstanding certain comments of the judges contained in the Swirsky decision?
(b) Does the CRA recognize that numerous years may pass before a corporation pays dividends, for example, a mineral or petroleum corporation in the exploration phase, without compromising interest deductibility on a loan to acquire common shares of such a corporation?
CRA response to Question 1(a)
The comments of the Tax Court of Canada in the Swirsky case respecting the absence of a history of payment of dividends have not effected a modification to our position in paragraph 31 of Interpretation Bulletin IT-533 respecting the deductibility of interest on a money borrowed for the purpose of acquiring common shares. Thus, where a taxpayer incurs a loan in order to acquire such shares on which no dividends have been paid, the interest respecting the loan will be deductible if we consider that at such moment there is a reasonable expectation of eventually receiving dividends on such shares. Of course, each situation must be considered on the basis of its particular facts.
CRA response to Question 1(b)
By itself, the fact that a corporation utilizes its entire liquidity for the purposes of carrying on its business for a certain period does not generally have the effect of limiting the potential for one of its shareholders to claim a deduction by virtue of subparagraph 20(1)(c)(i) of the Income Tax Act (the "ITA") in respect of money borrowed for the purpose of acquiring its shares. However, we would conclude that there is not a reasonable expectation of receiving dividends when the facts and documents indicate clearly that the permanent policy ["politique permanente"] of the corporation is to not pay dividends on the shares in question.
Sylvain Grégoire
(450) 926-7472
2014-053481