Principal Issues: Can a parent company that has received all accumulated profits from the subsidiaries borrow and return its accumulated profits to its shareholders?
Position: Generally Yes
Reasons: Meets exception to direct use test discussed in paragraph 23 of IT-533
XXXXXXXXXX 2004-010372 C. Tremblay 957-2139 January 21, 2005
Dear XXXXXXXXXX:
Re: Subparagraph 20(1)(c)(i) of the Income Tax Act (the "Act")
This is in reply to your letter of November 9, 2004, wherein you enquired whether the "purpose test" in subparagraph 20(1)(c)(i) of the Act is met in the example given in your letter.
You describe a situation where a parent corporation has a number of subsidiary corporations, all of which are engaged in an active business. The parent company acts as the "banker" for its subsidiaries, it contributes funds to the subsidiaries as required and the subsidiaries loan surplus funds to the parent as such funds accumulate during the year. Before the end of each taxation year, the subsidiaries declare dividends to the parent company out of accumulated profits. A large portion of the dividends are not paid in cash, but are satisfied by setting off loans owing by the parent company to the subsidiary corporations. The parent has thus accumulated profits in excess of its cash resources and wishes to borrow money to return capital to its shareholders. You question whether the entire amount of the parent company's accumulated profits can be considered to have been "used for purposes that would have qualified for interest deductibility had the capital been borrowed money".
Our Comments:
Written confirmation of the tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an advance income tax ruling request. Where the particular transactions are completed, the inquiry should be addressed to the relevant tax services office. However, we are prepared to provide the following general comments, which may be of assistance.
Paragraph 20(1)(c) of the Act permits the deduction of an amount paid in the year or payable in respect of the year, pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from a business or property. The Supreme Court has outlined that direct use is the primary test to determine interest deductibility and that indirect uses will not be acceptable, other than in exceptional circumstances. Trans-Prairie Pipelines Ltd. (70 DTC 6351) is the leading case with regard to exceptional circumstances and remains valid today. This case addressed the exceptional circumstances of borrowing to redeem shares. The concept of using borrowed money to "fill the hole" of capital withdrawn from the corporation's business is a key element of this concept.
A corporation may borrow to pay dividends to the extent of its accumulated profits or retained earnings. Generally, accumulated profits means retained earnings computed on an unconsolidated basis with investments accounted for on a cost basis. However, gains resulting from the disposition of property to persons with whom the taxpayer does not deal at arm's length will generally be excluded. In Chase Manhattan Bank of Canada v. The Queen, 2000 DTC 6018, the Court upheld the position that interest on borrowed money used to pay dividends, to the extent the loan exceeds retained earnings, is not deductible.
Where a parent corporation borrows money to return capital to its shareholders from its accumulated profits in a situation similar to the one described, the interest-bearing loan would generally meet the exception to the direct use test as discussed in paragraph 23 of IT-533. In our opinion, the interest deductibility may be provided under the "exceptional circumstances" category consistent with the concept of borrowing to replace capital to "fill the hole", with the understanding that the dividends paid by the subsidiary corporations to the parent corporation do not exceed their respective accumulated profits and none of the accumulated profits in any of the corporations represent gains from dispositions of property to non-arms length persons.
The foregoing comments represent our general views with respect to the subject matter. As indicated in paragraph 22 of Information Circular 70-6R5, the above comments do not constitute an income tax ruling and accordingly are not binding on the Canada Revenue Agency. Our practice is to make this disclaimer in all instances in which we provide an opinion.
We trust the above comments will be of assistance to you.
Yours truly,
Steve Tevlin
For Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Planning Branch