Principal Issues: [TaxInterpretations translation] Is interest on amounts due to shareholders of a company deductible from the company's income?
Position: No.
Reasons: The conditions for the application of paragraph 20(1)(c) are not satisfied.
May 18, 2006
Quebec Tax Services Office Headquarters
Technical Advisors Direction des décisions
Attention: Mr. Roch Méthot Michel Lambert
(613) 957-89532006-018232
XXXXXXXXXX
This is in response to your facsimile of April 12, 2006, concerning XXXXXXXXXX (the "Taxpayer"). On March 30, 2006, representatives of the Taxpayer sent you comments on our memorandum of March 3, 2006. You wish to obtain our opinion following the additional comments of March 30, 2006.
Unless otherwise indicated, all statutory references herein are to provisions of the Income Tax Act (the "Act").
Our Opinion
The Taxpayer's representatives point out that the notes issued to pay the dividends were paid for by loans made by the Taxpayer's shareholders. They also argue that the parties could have proceeded otherwise and that the interest would then have been deductible.
We have not analyzed the alternative situations since this is not relevant for establishing whether the interest is deductible. In that regard, the courts have repeatedly indicated that the legal relationships between taxpayers must be considered in determining the tax treatment of transactions between them. The decision of the Supreme Court of Canada in Shell Canada Ltd. Canada, 1999 DTC 5669 is a recent decision supporting that principle. Consequently, we are of the view that the legal relationship between the Taxpayer and its three shareholders must be considered in determining whether the interest paid by the Taxpayer to its three shareholders is deductible in computing its income. For the same reasons, we do not express an opinion on those alternative situations.
In this situation, notes have been issued for the payment of dividends. According to paragraph 29 of IT-533, interest on notes issued for the payment of dividends is not deductible since no property is acquired in such cases, as required by subparagraph 20(1)(c)(ii).
The Taxpayer's representatives state that the original non-interest bearing notes issued to pay the dividends were paid for by loans from the Taxpayer's shareholders. They also state that the Taxpayer made the loans from its shareholders in order to honour the payment of the dividends. As stated above, it is the legal relationship between the parties that must be considered. In that regard, we understand that the notes were issued upon payment of the dividends. In our view, the interest-bearing debt was not used to pay the dividends.
The Taxpayer's representatives refer to a concept that is sometimes used by the courts and that is referred to in Interpretation Bulletin IT-533 as the "filling the hole" principle. To our knowledge, there is no jurisprudence dealing with filling the hole in a situation such as the one under review. Since the concept of filling the hole is an exceptional circumstance for the purpose of allowing interest deductions, we cannot apply it in this case.
Access to Information
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We hope that these comments are of assistance.
Manager
Financial Sector and Exempt Entities Section
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch