Deductibility of Interest on Money Borrowed to Acquire Common Shares
The CRA has a longstanding administrative position of allowing taxpayers to claim a deduction for interest paid on money borrowed to purchase common shares of a corporation where the corporation has either
- no stated dividend policy or
- a dividend policy of paying dividends
when operational circumstances permit, on the basis that the purpose test in paragraph 20(1)(c) is met. The CRA’s position traditionally has also been that if a corporation has asserted that it does not pay dividends or that dividends are not expected to be paid in the foreseeable future, the purpose test in paragraph 20(1)(c) is not met. 30
Question
Will the CRA confirm that it continues to adopt the position on this issue that it has traditionally held, as described above, that is, that it is not necessary for the borrower to be able to point to a history of actual dividend payments by the corporation or to a policy that it will pay dividends in order to be entitled to deduct all interest on the borrowed money?
Response
In Ludco Enterprises Ltd. v. Canada, 31 the Supreme Court of Canada noted that the requisite purpose test for interest deductibility is whether, considering all of the circumstances, the taxpayer had a reasonable expectation of income at the time that the investment was made and that absent a sham, window dressing or other vitiating circumstances, a taxpayer’s ancillary purpose may be nonetheless a bona fide objective of his or her investment, equally capable of providing the requisite purpose for interest deductibility.
The CRA’s general views regarding interest deductibility are contained in the Interpretation Bulletin IT-533. 32 Specifically, it continues to be our view that:
“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 CRA 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.” 33
With respect to determining whether a common share investor has a reasonable expectation of income at the time the investment is made, in our view, it is not essential that dividends be received. This is merely one of many facts that would be considered. The dividend policy, if any, of the invested-in corporation would be another of the facts considered in such a determination, as well as evidence, if any, from corporate officials indicating whether dividends are expected to be paid, or whether shareholders are required to sell their shares in order to realize their value.
Each situation involving the investment of borrowed money in common shares must be dealt with on the basis of the particular facts involved, and the requisite test to be met for interest deductibility is whether the taxpayer had a reasonable expectation of income at the time the investment was made. The requisite test will not be met in all situations. Where the taxpayer, based on a review of the particular facts, did not have a reasonable expectation of income at the time the investment in common shares was made, the requirements of paragraph 20(1)(c) of the Act will not be met.
For instance, consider the situation of a foreign grandparent and parent with a wholly-owned Canco, which itself has a foreign subsidiary that has not paid dividends since its acquisition years earlier. Assume that Canco borrows funds, at interest, from its foreign parent and uses the funds to acquire additional shares in its foreign subsidiary, which immediately on-loans the proceeds to the foreign grandparent at 0% interest. In this situation, because the foreign subsidiary will not use the proceeds in its business to generate income, combined with the fact that it has a history of not paying dividends, in our view, Canco does not have a reasonable expectation of income at the time the additional shares of the foreign subsidiary were acquired, and therefore the requirements of paragraph 20(1)(c) of the Act are not met.
Link to Source: https://www.canada.ca/en/revenue-agency/services/forms-publications/publications/itnews-41/archived-income-tax-technical-news-no-41.html#P10