Principal Issues: [TaxInterpretations translation] In a situation where a corporation borrows from an arm's length financial institution an amount of money equal to its retained earnings ("RE") for the purpose of paying a dividend to its shareholders, would the interest payable on the borrowed money be deductible if the corporation had received, immediately prior to the borrowing, a stock dividend from its wholly owned subsidiary and that stock dividend had increased its RE?
Position: General comments.
Reasons: Question of fact.
XXXXXXXXXX 2007-024960 Guy Goulet CA, M.Fisc. March 18, 2008
Dear Sir,
Subject: Interest deductibility
This is further to your letter of August 16, 2007, requesting our comments regarding interest deductibility where a corporation borrows from an arm's length financial institution an amount equal to its retained earnings ("RE") for the purpose of paying a dividend to its shareholders. In the situation you described, the corporation in question was a Canadian-controlled private corporation that received a stock dividend from its wholly-owned subsidiary immediately before the borrowing. You informed us that under generally accepted accounting principles, the stock dividend received by the corporation increased its RE.
Unless otherwise indicated, all statutory references herein are to provisions of the Income Tax Act (the "Act").
Our Comments
It appears to us that the situation described in your letter may be an actual situation involving taxpayers. The Canada Revenue Agency ("CRA") does not generally provide written opinions on proposed transactions otherwise than by advance rulings. Furthermore, it is the responsibility of the relevant Tax Services Office to determine whether completed transactions have received appropriate tax treatment. However, we can offer the following general comments that we hope may be helpful to you. These comments may, however, under certain circumstances, not apply to your particular situation.
Subparagraph 20(1)(c)(i) allows a deduction for interest where all the conditions set out therein are satisfied. In particular, the amount to be deducted must be paid or payable in satisfaction of a legal obligation to pay interest on money borrowed and used to earn 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 indirect use may be accepted as an exception to the direct use test. As discussed in paragraph 23 of Interpretation Bulletin IT-533 Interest Deductibility and Related Issues, it is our view that where dividends are paid, borrowed money used to replace accumulated profits of a corporation that had been retained and used for eligible purposes may be an exception to the direct use test.
For this purpose, it is our view that a particular corporation's accumulated profits generally represent its RE, calculated on a non-consolidated basis, while investments are recorded at cost and generally reflect transactions that occur in the normal course of business between parties not dealing with each other at arm’s length. We consider that the impact on accumulated earnings of other non-arm's length transactions must be considered in light of the facts of each particular situation.
Paragraph (c) of the definition of "amount" in subsection 248(1) provides that the amount of any stock dividend is the amount by which the paid-up capital of the corporation that paid the dividend is increased by reason of the payment of the dividend.
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 request. Among other things, we do not know the amount of capital of the shares of the subsidiary resulting from the stock dividend and the accumulated profits of the subsidiary before the stock dividend. We would be pleased to consider this matter in the context of a request for advance rulings made pursuant to Information Circular 70-6R5 dated May 17, 2002 by a taxpayer or the taxpayer’s duly authorized representative.
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.