A corporation finances the purchase for cancellation (“redemption”) of shares in its capital for $1,000 with $500 borrowed from a financial institution (the “Borrowed Amount”) and through the issuance of two notes (Note #1 and Note #2) for $300 (bearing interest) and $200 (non-interest bearing) payable to the redeemed shareholder) (to fund part of purchases for cancellation of shares of its capital stock owned by a shareholder. The total contributed capital for the redeemed shares is $1 and the corporation’s accumulated profits are $800 (collectively, the “Eligible Capital”), have an eligible use.
When asked to comment on the deductibility of interest on the Borrowed Amount and Note #1, CRA stated:
The issue to be resolved in this case would be to establish, in accordance with the concept of "filling the hole", the proportion of the Borrowed Amount, and of Note #1 and Note #2, that would replace the $801 of Eligible Capital for the shares purchased and cancelled (i.e. $1 of contributed capital and $800 of accumulated profits). With respect to the contributed capital of the shares purchased and cancelled in the amount of $1, we believe that this amount would be replaced proportionally by a fraction of the Borrowed Amount and of Note #1 and Note #2. With respect to the $800 of accumulated earnings, we believe that the corporation could designate, at its discretion and up to a maximum amount of $800, all or part of the Borrowed Amount, Note #1 and Note #2 as borrowed money or debt used to replace accumulated earnings.