Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CCRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.
Principal Issues:
Whether interest is deductible on promissory note issued to redeem shares
Position: yes, to the extent that it replaces capital withdrawn from the business
Reasons: Oct 1, 2002 Presentation to the CTF
December 20, 2002
TORONTO WEST TSO HEADQUARTERS Basic Files Section Corporate Financing Section Attention: Bik Dewan Denise Dalphy, LL.B. (613) 941-1722
2002-015215
Deductibility of Interest on Money Borrowed to Redeem Shares
This is in response to your memorandum dated July 11, 2002 wherein you enquired whether interest on money borrowed by a taxpayer in order to purchase its shares on the open market are deductible under the Income Tax Act (the "Act").
Since the Supreme Court of Canada decisions in Ludco and Singleton, we have reviewed our existing positions on interest deductibility. On October 1, 2002, at the Canadian Tax Foundation Conference, we announced, among other things:
"I. Borrowing to redeem shares or return capital
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. 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 The concept of using borrowed money to "fill the hole" of capital withdrawn from the corporation's business is a key element of this concept. We accept these exceptional circumstances for interest deductibility provided that the capital replaced by the borrowing was previously used for an eligible purpose of earning income from a business or property. We further accept that borrowing to return capital could also apply in a partnership context.
J. How is capital calculated
Based on the preceding analysis, the amount of capital used for an eligible purpose of earning income prior to the replacement of that capital with borrowed money must be determined. We generally accept that capital includes the contributed capital and accumulated profits of a corporation or partnership.
Contributed capital is considered to be the funds provided by the owners of a corporation or partnership to commence or to further the carrying on of the corporate or partnership business. We accept that in most corporate situations the legal or stated capital for corporate law purposes would be the best measurement of capital for this purpose, although other measurements may be more appropriate depending upon the circumstances.
Generally, accumulated profits means retained earnings computed on an unconsolidated basis with investments accounted for on a cost basis. However, profits or gains resulting from the disposition of property to persons with whom the taxpayer does not deal at arm's length will generally be excluded.
The underlying concept remains that of "filling the hole" of capital withdrawn from the business.
In situations where some proportion of shares is being replaced with borrowed money, only the capital of those shares, computed on a pro-rata basis, would be considered to be replaced with the borrowed money. The accumulated profits of a corporation, however, do not track any particular shareholdings.
L. Notes issued to redeem shares
Where a note is issued to redeem shares, interest deductibility may be provided under the exceptional circumstances category, in accordance with the decision in Penn-Ventilator. Consistent with the exceptional circumstances described in I above, interest would be deductible to the extent of the interest on the amount of the notes issued within the limits for capital described in J above for redeeming shares or paying dividends. Interest on notes issued to pay dividends would not qualify for deduction since no property is acquired in such a transaction."
We hope the above opinion will assist you. If you would like to discuss this situation, please contact the writer.
Steve Tevlin
Manager
Corporate Financing Section
Financial Industries Division
Income Tax Rulings Directorate