Principal Issues: Is interest deductible by the sole shareholder of a company who uses borrowed money to fund an interest-free loan to the company, which loan is subsequently forgiven by the shareholder?
Position: Generally, yes.
Reasons: The condition in paragraph 7(1.31)(a) would not be met since there were two separate dispositions of identical securities
Financial Strategies and Financial Instruments Roundtable, October 9, 2015
2015 APFF Conference
Question 3
Deductibility of interest following the write-off of a receivable and subsection 20.1(1)
Consider the following situation. The sole shareholder of a Canadian-controlled private corporation ("CCPC") advances funds to the corporation to fund its activities. The sums advanced to the corporation come from a personal loan contracted by the shareholder. Interest paid on this personal loan is deductible in computing the shareholder's income, even if the advances to the corporation are non-interest bearing, in particular by virtue of The Queen v. Byram, 1999 FCA File A-684-94 ("Byram"). The CRA acknowledged the favorable effects of the Byram decision on several occasions when publishing technical interpretations.
The corporation, being unable to meet its financial obligations, filed a proposal under the Bankruptcy and Insolvency Act, R.S.C. (1985), c. B-3. In order to have the proposal accepted by the creditors, the shareholder has waived all the advances due to him.
In St-Hilaire v. The Queen, 2014 TCC 336 ("St-Hilaire"), the judge found that the interest paid by the shareholder after the acceptance of the proposal was not deductible (in a situation similar to that set out above) since the $253,985 receivable owed by the corporation to the shareholder ceased to exist as a result of the waiver provided in the proposal. If he had not waived, the maximum amount he would have received in the proposal would have been $10,000. In short, the advances of $253,985 had a maximum FMV of $10,000 at that time. According to the judge, the interest paid by the shareholder after that time was not derived from money borrowed for the purpose of earning income from property as required by paragraph 20(1)(c).
However, the Income Tax Act also contains section 20.1 which seems to have been overlooked in the St-Hilaire decision. Subsection 20.1(1) reads as follows:
Borrowed money used to earn income from property
20.1 (1) Where
(a) at any time after 1993 borrowed money ceases to be used by a taxpayer for the purpose of earning income from a capital property (other than real or immovable property or depreciable property), and
(b) the amount of the borrowed money that was so used by the taxpayer immediately before that time exceeds the total of
(i) where the taxpayer disposed of the property at that time for an amount of consideration that is not less than the fair market value of the property at that time, the amount of the borrowed money used to acquire the consideration,
(ii) where the taxpayer disposed of the property at that time and subparagraph 20.1(1)(b)(i) does not apply, the amount of the borrowed money that, if the taxpayer had received as consideration an amount of money equal to the amount by which the fair market value of the property at that time exceeds the amount included in the total by reason of subparagraph 20.1(1)(b)(iii), would be considered to be used to acquire the consideration,
(iii) where the taxpayer disposed of the property at that time for consideration that includes a reduction in the amount of the borrowed money, the amount of the reduction, and
(iv) where the taxpayer did not dispose of the property at that time, the amount of the borrowed money that, if the taxpayer had disposed of the property at that time and received as consideration an amount of money equal to the fair market value of the property at that time, would be considered to be used to acquire the consideration,
an amount of the borrowed money equal to the excess shall, to the extent that the amount is outstanding after that time, be deemed to be used by the taxpayer for the purpose of earning income from the property.
The conditions for the application of subsection 20.1(1) having been satisfied, this statutory provision appears to apply in the situation presented above. Thus, even if the source of income, that is to say, the advance made to the corporation, no longer exists, subsection 20.1(1) seems to permit the deductibility of the interest on the loan personally contracted by the shareholder to advance the sums to his corporation, even after the acceptance of the proposal which had the effect of eliminating the source of income.
Question to CRA
Is the CRA of the view that subsection 20.1(1) applies in the situation described above and that in such circumstances it is possible for the shareholder to continue to deduct the interest on his personal loan even after the acceptance of a proposal to eliminate the source of income associated with the shareholder's loan?
CRA Response
To begin with, note that the Byram case that you cited bears on the application of subparagraph 40(2)(g)(ii) to an interest-free loan and not on the deductibility of interest under subparagraph 20(1)(c)(ii) on money borrowed to make such a loan.
The position of the CRA in para. 1.55 of the Income Tax Folio S3-F6-C1 Deductibility of Interest, respecting the deductibility of interest on money borrowed by a shareholder which is used to provide an interest-free to a wholly-owned corporation is based on The Queen v. Canadian Helicopters Ltd., 2002 FCA 30.
In this paragraph of the Folio, we take the positon that a shareholder who uses borrowed funds to make an interest-free loan to a wholly-owned corporation can deduct interest paid or payable on this loan to the extent that the funds received by the corporation have an effect on its income-earning capacity, so that the common shares of the corporation can potentially generate increased dividends. In paragraph 1.56 of the same Folio, we take a similar position respecting borrowed money which is used to make a contribution of capital to a corporation of which the borrower is a shareholder.
In the situation presented, we are of the view that the actual use of borrowed money, following the debt cancellation, continues to be for the purpose of investing in the shares of the corporation. To the extent that the shareholder continues to hold all the shares of the corporation and there is a reasonable expectation of deriving dividends, we are of the view that the shareholder would comply with the conditions of subparagraph 20(1)(c)(i) and that it would not be necessary to refer to subsection 20.1(1).
The facts in the St-Hilaire case were different from those in your example. Furthermore, this decision does not constitute a jurisprudential precedent as it was rendered under the informal procedure.
Yves Grondin
2015-058895