Principal Issues: [TaxInterpretations translation] In a situation where a proportion of a corporation's shares would be repurchased with borrowed money and the issuance of notes, is the Eligible Capital of the repurchased shares (i.e., contributed capital and accumulated profits) replaced proportionally by the borrowed money and the notes?
Position: General comments.
Reasons: Numbers 23 and 29 of IT-533.
XXXXXXXXXX 2008-029673
Guy Goulet CA, M.Fisc.
May 27, 2009
Dear Sir,
Subject: Section 20(1)(c) of the Act
This is in response to your letter of October 10, 2008 in which you requested our comments regarding the deductibility of interest where a corporation effects the purchase for cancellation of shares of its capital stock owned by a shareholder. The purchase price of the shares so purchased for cancellation would be $1,000. To pay this purchase price, the corporation would borrow $500 from an arm's length financial institution (the “Borrowed Amount”) and would issue two notes payable to the shareholder, namely a first note in the amount of $300 which would bear interest at the market rate (Note #1) and a second non-interest bearing note in the amount of $200 (Note #2). You indicated that the total amount of the contributed capital for the shares purchased and cancelled would be $1 and that the total amount of the accumulated profits of the corporation immediately before the purchase of shares would be $800. Finally, you indicated that the amount of capital (contributed capital and accumulated profits) for the shares purchased and cancelled (Eligible Capital) in the amount of $801 would have been retained and used for purposes that would have qualified for interest deductibility if the capital had been borrowed.
Our Comments
It appears to us that the situation described in your letter may constitute an actual situation involving taxpayers. The Canada Revenue Agency ("CRA") does not generally provide written opinions on proposed transactions otherwise than by way of an advance income tax ruling. Furthermore, it is the responsibility of the relevant Tax Services Office to determine whether completed transactions have received appropriate tax treatment. We can, however, offer the following general comments that may not apply fully in a particular situation.
Subparagraphs 20(1)(c)(i) and (ii) allow the deduction of interest where all the conditions set out in those subparagraphs are satisfied.
Subparagraph 20(1)(c)(i) provides inter alia that the amount to be deducted must be paid or payable pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from a business or property. In light of the jurisprudence, while the applicable test is the direct use of borrowed money, it is possible that an indirect use can be an exception to the direct use test. As discussed in paragraph 23 of IT-533 Interest Deductibility and Related Issues, it is our view that in the case of share redemptions, borrowed money used to replace capital (contributed capital or accumulated profits) that has been used for eligible purposes can be an exception to the direct use test. Similarly, in the case of dividend payments (including deemed dividends), borrowed money used to replace accumulated profits of a corporation that had been retained and used for eligible purposes can be an exception to the direct use test.
Furthermore, subparagraph 20(1)(c)(ii) permits a deduction 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 the taxpayer’s income), pursuant to a legal obligation to pay interest on an amount payable for property acquired for the purpose of gaining or producing income from the property or for the purpose of gaining or producing income from a business (other than property the income from which would be exempt or property that is an interest in a life insurance policy) that is wholly applicable to that source of income, or such part of such interest that can reasonably be regarded as applicable thereto. As discussed in ¶ 29 of IT-533 Interest Deductibility and Related Issues, it is our view that where a note is issued to purchase and cancel (or otherwise redeem) shares, interest expense may be deductible under subparagraph 20(1)(c)(ii) to the extent of the interest on the amount of the note issued within the limits described in ¶ 23 of IT-533 for redeeming shares.
It is difficult for us to comment on the situation you have submitted to us as we do not have all the relevant facts and circumstances surrounding the transactions described in your application. 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.
We hope that our comments are of assistance.
Best regards,
Ghislain Martineau
Manager
Financial Sector and Exempt Entities Section
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch.