28 June 2006 External T.I. 2006-0172111E5 - ABIL

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: The taxpayer borrowed money and lent it interest free to a corporation of which he owns XXXXXXXXXX per cent of the common shares. The corporation no longer generates any revenue and there is no expectatoin that it will earn any income in the future. Can the taxpayer claim an allowable business investment loss in respect of the loan?

Position: Question of fact. General comments given.

Reasons: Based on the Byram decision, where a clear connection between the shareholder and the corporation's dividend icnome can be demonstrated, subparagraph 40(2)(g)(ii) should not be applied to deny the capital loss. It is a question of fact whether such a connection exists.

2006-017211
XXXXXXXXXX G. Moore
(613) 957-9232
June 28, 2006

Dear XXXXXXXXXX:

Re: Allowable Business Investment Loss

This is in response to your letter of February 16, 2006, inquiring about allowable business investment losses.

As we understand it, you formed a web-based business in 2004 along with XXXXXXXXXX other partners. The business was incorporated and each partner was issued XXXXXXXXXX common shares. You borrowed money from the bank via an unsecured line of credit and loaned the money interest-free to the corporation. In 2005, you and your partners decided to leave the website for the business up and running but decided not to devote any more time to the business. You do not have a reasonable expectation of earning any revenue from the business in the future. The borrowed money is still outstanding and you have claimed the interest expense as a deduction on your returns. You are asking if you can claim the unpaid principal of the interest-free loan as an allowable business investment loss ("ABIL"). You are also asking if you can continue to deduct the interest on the money borrowed on your future tax returns.

The situation outlined in your letter appears to relate to a factual one, involving a specific taxpayer. It is not this Directorate's practice to comment on proposed transactions involving specific taxpayers other than in the form of an advanced income tax ruling. For more information about how to obtain a ruling, please refer to Information Circular 70-6R5, "Advanced Income Tax Rulings, dated May 17, 2002. This Information Circular and other CRA publications can be accessed on the internet at http://www.cra-arc.gc.ca. Should your situation involve a specific taxpayer and a completed transaction, you should submit all relevant facts and documentation to the appropriate Tax Services Office ("TSO") for their views. A list of TSOs is available on the "Contact Us" page of the CRA website. Although we cannot comment on your specific situation, we are prepared to provide the following general comments, which may be of assistance.

Allowable Business Investment Losses

The CRA's general views regarding ABILs can be found in Interpretation Bulletin

IT-484R2, Business Investment Losses. A taxpayer's business investment loss may arise from the disposition of (a) a share of a corporation that is a small business corporation, or (b) a debt owing to the taxpayer by a Canadian-controlled private corporation. For the loss on the disposition of such property to qualify as a business investment loss, the disposition must be to an arm's length person or be deemed to have occurred under subsection 50(1) of the Act. For the meaning of "small business corporation" and "Canadian-controlled private corporation," see paragraph 4 of IT-484R2.

Subsection 50(1) of the Act deems a taxpayer to have disposed of a debt at the end of a taxation year for nil proceeds and to have reacquired it immediately thereafter at a cost of nil if, in the case of a debt (other than a debt from the sale of personal use property), the debt is owing to the taxpayer at the end of the taxation year and it is established by the taxpayer to have become a bad debt in the year. If subsection 50(1) applies, the taxpayer is deemed to have disposed of the property for nil proceeds and a capital loss will arise. The time at which a debt becomes a bad debt is a question of fact and any decision made will be dependent upon the circumstances in each case. A determination by a creditor that a debt has become bad in a particular taxation year must be supported by all relevant and material facts. A debt is considered bad for the purpose of section 50 of the Act only when the whole amount is uncollectible or when a portion of it has been settled and the remainder is uncollectible. Generally, a debt will not be considered uncollectible at the end of a particular taxation year unless the creditor has exhausted all legal means of collecting it or the debtor has become insolvent and has no means of paying it. In the situation you described, in order for your debt to be treated as a bad debt you would have to establish that the debt is uncollectible at the end of a particular taxation year and that the debtor corporation is insolvent and has no means of repaying the debt to you.

Under subparagraph 40(2)(g)(ii) of the Act, a taxpayer's loss arising from the disposition of a debt is nil (and therefore cannot result in a capital loss) unless the debt had been (i) acquired by the taxpayer for the purpose of gaining or producing income from a business or property (other than exempt income); or (ii) acquired as consideration for the disposition of capital property in an arm's length transaction. For the purposes of subparagraph 40(2)(g)(ii) of the Act, money which has been loaned at a reasonable rate of interest generally constitutes a debt acquired for the purpose of gaining or producing income, and any capital loss which arises because it has become uncollectible is generally not deemed to be nil by virtue of subparagraph 40(2)(g)(ii) of the Act. The loss arising to the taxpayer from the corporation's inability to discharge its obligations to the taxpayer may be a deductible capital loss that is not deemed to be nil by subparagraph 40(2)(g)(ii) .

In holding that certain losses were allowable, the Federal Court of Appeal in the Edwin J. Byram decision (99 DTC 5117) stated:

"The language of section 40 is clear. The issue is not the use of the debt, but rather the purpose for which it was acquired. While subparagraph 40(2)(g)(ii) requires a linkage between the taxpayer (i.e. the lender) and the income, there is no need for the income to flow directly to the taxpayer from the loan.

Such an approach is also consistent with commercial reality. Frequently, shareholders make such loans on an interest-free basis anticipating dividends to flow from the activities financed by the loan...

The ultimate purpose of a parent company or a significant shareholder providing a loan to a corporation is, without question, to facilitate the performance of that corporation thereby increasing the potential dividends issued by the company...

There is a growing body of jurisprudence that considers current corporate reality as being sufficient to demonstrate that the expectation of dividend income justifies a capital loss deduction under subparagraph 40(2)(g)(ii). As articulated above, this approach is consistent with current corporate realities and the purpose of subparagraph 40(2)(g)(ii)...

The shareholders of a company are directly linked to that corporation's future earnings and its payment of dividends. Where a shareholder provides a guarantee or an interest free loan to that company in order to provide capital to that company, a clear nexus exists between the taxpayer and the potential future income. Where a loan is made for the purpose of earning income through the payment of dividends, this connection is sufficient to satisfy the purpose requirement of subparagraph 40(2)(g)(ii)."

The CRA indicated in Income Tax Technical News #18 that it has accepted the decision in Byram.

In the situation you described, the issue is whether the connection between a minority shareholder, and potential dividend income from the corporation, is sufficient to satisfy the requirement of subparagraph 40(2)(g)(ii) of the Act that the loan was made for the purpose of earning income. Since you had a 20% minority interest in the corporation, at the time the investment was made, it is a question of fact whether the future dividend stream from your shares in the corporation would have been sufficient to recoup the loan to the corporation. It is also a question of fact whether the loan was made for the purpose of earning income through the receipt of dividends. If, based on the facts of the case, you can establish that the purpose of the loan was to earn income through dividends, then the purpose test in subparagraph 40(2)(g)(ii) of the Act would be met.

Interest Deductibility

Interest on borrowed money is deductible pursuant to paragraph 20(1)(c) of the Act where the borrowed money is used for the purpose of earning income from a business or property. Section 20.1 of the Act applies where, because of a loss of source of income, borrowed money ceases to be used for an income-earning purpose. These rules ensure that interest on such borrowed money will, in certain circumstances, continue to be deductible under paragraph 20(1)(c) of the Act provided all the conditions of this paragraph are met. Generally, borrowed money will cease to be used for the purpose of earning income from a property when the taxpayer sells or otherwise disposes of the property. However, in some circumstances, borrowed money may cease to be so used while the taxpayer still owns the property - for example, where a taxpayer has used borrowed money to acquire shares of a corporation that has subsequently become bankrupt. In the situation you described, we do not have sufficient information to determine whether the borrowed money has ceased to be used for the purpose of earning income since you indicated in your letter that the web site is still up and running. You have also not indicated whether the business disposed of any property. You may find additional information on the "disappearing source" rules in paragraph 19 of IT-533, Interest Deductibility and Related Issues.

We trust that these comments will be of assistance.

Yours truly,

S. Parnanzone
Manager
Business Incentives and Capital Transactions Section
Business and Partnerships Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch