8 March 1996 Ministerial Letter 9531918 - LOANS TO PRODUCE INCOME

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

Whether for purposes of subparagraph 40(2)(g)(ii) the "income purpose test" can be indirect.

Position TAKEN:

Where it is outside the purview of the Department's administrative position in IT-239R2, the income has to be direct rather than indirect by way of dividends and management fees.

Reasons FOR POSITION TAKEN:

Based on Bronfman 87 DTC 5089. Also, Byram 95 DTC 5069 appealed on same basis as the Bronfman decision.

								March 8, 1996

	Appeals Branch					HEADQUARTERS
	Appeals & Referrals Division		M. Brake
P. J. Murphy					957-8953
	Section Chief

	Attention: Neil Wilson
								953191

John Burns et al - 94 DTC 1370 Subparagraph 40(2)(g)(ii)

This is in response to your memorandum of May 18, 1995, wherein you requested our comments with regard to the interpretation of the phrase "acquired by the taxpayer for the purpose of gaining or producing income from a business or property", in subparagraph 40(2)(g)(ii) in relation to the above-noted case. At pages 1378 and 1379, the Court stated:

"the wording does not require a direct link between the loan and the business or property which produces the income."

and

"The question that must then be answered is whether or not the purpose of the appellants in gaining income has sufficient nexus with making a loan. The benefit to them had to travel a circuitous, albeit not tortuous, route in order to come home to roost."

In the Burns case, the taxpayers (who were siblings and the shareholders of BFL), each loaned $50,000 to WFC, a corporation which was owned by their brother. The only link between the loans and the return the taxpayers could expect on their loans was that their corporation (BFL) was entitled to reduced prices, if and when it purchased or rented equipment from WFC. Such savings might translate into increased earnings for the taxpayers' corporation (BFL) and increased dividends in their hands.

Our comments

The position set out in paragraph 6 of IT-239R2 with respect to the deductibility of capital losses resulting from loans to a Canadian corporation at less than reasonable rates is an administrative concession only. It should not be interpreted as indicating that subparagraph 40(2)(g)(ii) of the Act will not apply if a loan generates income, regardless how tenuous the causal link between the loan and the income produced. In the Burns case, the Department contended that the loans made by the taxpayers were not made for the purpose of gaining or producing income since, in order to avoid the application of subparagraph 40(2)(g)(ii), the income has to be directly produced by the loan rather than indirectly by other property, such as shares or by way of management fees. While there were a couple of transactions that resulted in the taxpayers' corporation saving money, in our view, any income these savings might generate for the taxpayers would not be sufficiently attractive to incite a non-arm's length shareholder, under similar circumstances, to make a loan. Hence, it is not reasonable to assume that the "good deal, discount arrangement" was the purpose for making the loan. The fact that the loans were made to a corporation owned by the taxpayers' brother was a much stronger motivating factor for making the loans than was their tenuous income-producing aspect.

It should also be noted that, in this case, the Court held that part of the loans became bad debts in 1986 and the remainder in 1987. This is contrary to the Department's position set out in paragraph 10 of IT-159R3, according to which a debt is considered bad for the purpose of section 50 only when the whole amount is uncollectible or when a portion of it has been settled and the remainder is uncollectible. Otherwise, where a portion of a debt can be considered uncollectible, this portion is not considered to be bad for the purpose of section 50, even though the accounting practice may require a write-down to realizable value.

As you are no doubt aware, the Department is appealing a similar case, Edwin J. Byram v. Her Majesty the Queen (95 DTC 5069 FC), involving interest free loans to foreign corporations, on the basis that the case was wrongly decided in light of the Supreme Court of Canada decision in Bronfman Trust, 87 DTC 5059. Therefore, given the decision in the Bronfman Trust case and the fact that the Department is appealing the Byram case, in our view, the indirect nexus test applied in the Burns case should not, at this time, be used in interpreting subparagraph 40(2)(g)(ii) of the Act.

We apologize for the delay in replying.

C. Chouinard
for Director
Business and General Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch