2015-0601211E5 Mortgage loan from RRSP to make a shareholder loan

Principal Issues: 1) Is interest paid on borrowed money deductible when the use of the funds is to make a non-interest bearing shareholder loan? (2) Is a mortgage loan a qualified investment for the subject RRSP by virtue of paragraph (d) of the definition “qualified investment” in subsection 146(1) of the Act and paragraph 4900(1)(j.1) of the Regulations? (3) Is the taxpayer’s use of the funds to make a shareholder loan an eligible use of the property of the RRSP?

Position: (1) General comments provided. (2) Yes. (3) Yes, but the advantage rules and prohibited investment rules must be considered. General comments provided.

Reasons: (1) Question of fact. (2) The provisions of paragraph 4900(1)(j.1) of the Regulations. (3) The legislation. Questions of fact.

Author: Pietrow, Victor
Section: 20(1)(c); 146(1) “qualified investment”; 207.01(1) “advantage”, “excluded property”, “prohibited investment”, “RRSP strip”; Paragraph 4900(1)(j.1)

XXXXXXXXXX                                                                                                          2015-060121
                                                                                                                                  Victor Pietrow
                                                                                                                                   613-404-2142
June 1, 2016

Dear Mr. XXXXXXXXXX:

Re:  Proceeds of a Mortgage Loan from an RRSP used to make a Shareholder Loan

We are writing in reply to your correspondence of July 28, 2015 in connection with the use of the proceeds of a mortgage loan from a registered retirement savings plan (RRSP).

This technical interpretation provides general comments about the provisions of the Income Tax Act (the “Act”) and related legislation (where referenced). It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of particular transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R7, Advance Income Tax Rulings and Technical Interpretations.

In your hypothetical example, an individual would borrow funds (the “Mortgage Loan”) from his/her RRSP (the “subject RRSP”).  The repayment of the funds would be secured by a mortgage granted in favour of the RRSP by the individual on his/her principal residence, which is located in Canada.  The Mortgage Loan would be administered by an approved lender under the National Housing Act and would be insured as required by paragraph 4900(1)(j.1) of the Income Tax Regulations (the “Regulations”) by a corporation described by clause (B) of that paragraph. The individual would use the proceeds of the Mortgage Loan to make a shareholder loan (the “Shareholder Loan”) to a corporation (the Corporation”) in which he/she holds shares and that he/she controls. The Corporation would use the proceeds of the Shareholder Loan to pay off a corporate line of credit where the interest is currently deductible by the Corporation pursuant to paragraph 20(1)(c) of the Act.  The stated purpose of the Shareholder Loan is for the individual to receive dividends in the future from the Corporation. We assume that the Shareholder Loan is non-interest bearing as you have indicated that, to meet the reasonable expectation of income test under paragraph 20(1)(c) of the Act, the purpose of the Shareholder Loan is to earn dividend income.

You requested our view as to whether the interest paid by the individual to the subject RRSP on the Mortgage Loan is deductible under subparagraph 20(1)(c)(i) of the Act.  You also requested our view as to whether the Mortgage Loan is a qualified investment for the subject RRSP by virtue of paragraph (d) of the definition “qualified investment” in subsection 146(1) of the Act and paragraph 4900(1)(j.1) of the Regulations. Finally, you asked whether the individual’s use of the funds received on the Mortgage Loan to make the Shareholder Loan is an eligible use of the property of the subject RRSP.

Our Comments

A. Interest deductibility

Subparagraph 20(1)(c)(i) of the Act provides a deduction to a taxpayer for an amount paid in the year or payable in respect of the year (depending on the method regularly followed by the taxpayer in computing his or her income) pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from a business or property, with certain exceptions.

In this case, since the Shareholder Loan is non-interest bearing, the direct use test (i.e., whether borrowed money is directly used for the purpose of earning income) is not met and the issue is whether there is an eligible indirect use for the purposes of meeting the requirements of paragraph 20(1)(c).

The determination as to whether there is an eligible indirect use of borrowed money, for the purposes of paragraph 20(1)(c) of the Act, is discussed in paragraphs 1.54 and 1.55 of Income Tax Folio S3-F6-C1, Interest Deductibility (“Folio”):

1.54 Interest expense on borrowed money used to make an interest-free loan is not generally deductible since the direct use is to acquire a property that cannot generate any income. However, where it can be shown that this direct use can nonetheless have an effect on the taxpayer’s income-earning capacity, the interest may be deductible.

1.55 Such was the case in [The Queen v.] Canadian Helicopters Limited, where the Federal Court of Appeal found that the taxpayer had a reasonable expectation of earning income from the indirect use of the borrowed money, which was used to make an interest-free loan. Generally, a deduction for interest will be allowed if borrowed money is used to make an interest-free loan to a wholly-owned corporation (or in cases of multiple shareholders, where shareholders make an interest-free loan in proportion to their shareholdings) and the proceeds have an effect on the corporation’s income-earning capacity. That is, an increase in the income-earning capacity of the corporation will increase the parent’s (or shareholders’) potential future dividend income from the corporation (indirect eligible use). Such a determination will depend upon the facts of a particular situation.

As noted in the Folio, there are circumstances in which interest expense on borrowed money used to make an interest-free shareholder loan may be deductible. However, one of the criteria is that the interest-free loan must be made to a wholly-owned corporation (or in the case of multiple shareholders, there are interest-free loans made by all the shareholders in proportion to their shareholdings). It is not indicated in the example you provided whether or not this requirement is met. If the interest-free loan is made to a wholly-owned corporation and the Shareholder Loan is used to pay off a corporate line of credit where the interest is currently deductible by the Corporation under paragraph 20(1)(c) of the Act such that it increases the Corporation’s income-earning capacity (i.e., by reducing the Corporation’s interest expense) and the shareholders’ potential future dividend income from the Corporation, then the interest may be deductible under paragraph 20(1)(c) in the example you provided.

B. RRSP

In our view, if the Mortgage Loan is administered by an approved lender under the National Housing Act and is insured as required by paragraph 4900(1)(j.1) of the Regulations, the Mortgage Loan would satisfy the requirements of that paragraph and would therefore be a qualified investment for purposes of the subject RRSP by virtue of paragraph (d) of the definition “qualified investment” in subsection 146(1) of the Act.

There are no express restrictions under paragraph 4900(1)(j.1) of the Regulations on the individual’s use of the funds received on the Mortgage Loan.  However, the advantage and prohibited investment rules in Part XI.01 of the Act must be considered.

1) Advantage rules

With respect to the advantage rules, paragraphs (a) and (d) of the definition of “advantage” in subsection 207.01(1) of the Act are relevant.

Paragraph (a) of the definition of “advantage”

In our view, the granting of the Mortgage Loan would be a benefit conditional on the existence of the subject RRSP. Therefore, there would be an advantage by virtue of paragraph (a) of the definition of “advantage” unless the exception provided by subparagraph (a)(ii) of that definition applies.  That exception applies if the terms and conditions of the Mortgage Loan are terms and conditions that persons dealing at arm’s length with each other would have entered into.  In our view, the terms and conditions of a mortgage loan that satisfies the requirements of paragraph 4900(1)(j.1) of the Regulations would, because of the underlying nature of those requirements, usually be terms and conditions that persons dealing at arm’s length with each other would have entered into; therefore, in such a case, the exception provided by subparagraph (a)(ii) of the definition “advantage” would likely be met. However, the determination of whether the exception provided by subparagraph (a)(ii) of the definition “advantage” would be met in a situation like the example you provided is a question of fact and would require a detailed examination of all relevant facts and circumstances.

Furthermore, a benefit conditional on the existence of the subject RRSP (and therefore an advantage under paragraph (a) of the definition of “advantage”) could arise after the granting of the Mortgage Loan if, for example, there is a default by the borrower and he/she is enriched as a result of the default.

Paragraph (d) of the definition of “advantage”

If there is an RRSP strip in respect of the subject RRSP, there is an advantage by virtue of paragraph (d) of the definition of “advantage”.  Generally speaking, an RRSP strip in respect of an RRSP is the amount of a reduction in the fair market value of the property of the RRSP if two tests are met. The first test is whether the fair market value of the property of the RRSP is reduced as part of a transaction or event or series of transactions or events. The second test (the “purpose test”) is whether one of the purposes of the transaction or event or series of transactions or events is to enable the RRSP annuitant (or a person who does not deal at arm’s length with the RRSP annuitant) to obtain a benefit in respect of property of the RRSP or to obtain a benefit as a result of the reduction.

In our view, where a mortgage loan that satisfies the requirements of paragraph 4900(1)(j.1) of the Regulations is granted by an RRSP, the underlying nature of those requirements is such that the fair market value of the property of the RRSP is not usually reduced immediately after the granting of the mortgage loan. However, an RRSP strip could arise after the granting of the Mortgage Loan if, for example, there is a default under the Mortgage Loan by the borrower, the subject RRSP sustains a loss of principal or interest under the Mortgage Loan as a result of the default, the loss or a portion of the loss is not covered by the mortgage default insurance policy, and the purpose test in the definition of “RRSP strip” is met.

The determination of whether there is an RRSP strip in a situation like the example you provided is a question of fact and would require a detailed examination of all relevant facts and circumstances.

2) Prohibited investment rules

Since a mortgage loan that satisfies the requirements in paragraph 4900(1)(j.1) of the Regulations is excluded property (as defined in subsection 207.01(1) of the Act), the mortgage loan would not be a prohibited investment (as defined in that subsection) for the RRSP.

We trust that our comments will be of assistance.

Lita Krantz, CPA, CA
For Director
Financial Industries and Trusts Division
Income Tax Rulings Directorate

All rights reserved. Permission is granted to electronically copy and to print in hard copy for internal use only. No part of this information may be reproduced, modified, transmitted or redistributed in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, or stored in a retrieval system for any purpose other than noted above (including sales), without the prior written permission of Canada Revenue Agency, Ottawa, Ontario K1A 0L5.

© Her Majesty the Queen in Right of Canada, 2016

Tous droits réservés. Il est permis de copier sous forme électronique ou d'imprimer pour un usage interne seulement. Toutefois, il est interdit de reproduire, de modifier, de transmettre ou de redistribuer de l'information, sous quelque forme ou par quelque moyen que ce soit, de façon électronique, mécanique, photocopies ou autre, ou par stockage dans des systèmes d'extraction ou pour tout usage autre que ceux susmentionnés (incluant pour fin commerciale), sans l'autorisation écrite préalable de l'Agence du revenu du Canada, Ottawa, Ontario K1A 0L5.

© Sa Majesté la Reine du Chef du Canada, 2016