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 equity accounting may be used to determine accumulated profits for the purpose of interest deductibility to pay dividends/return capital
Position: no
Reasons: this measurement can reflect more than the capital of the borrowing corporation and is therefore not permitted.
December18, 2002
TORONTO WEST TSO HEADQUARTERS 8th Floor Corporate Financing Section Denise Dalphy, LL.B. Attention: Mr. Paul Stesco (613) 941-1722
2002-016174
Debt Used to Pay Dividends
XXXXXXXXXX
This is in response to your memoranda dated September 6 and October 2, 2002 wherein you enquired whether, in determining whether interest is deductible under the Income Tax Act (the "Act") in respect of debt that was used to finance dividend payments or the return of capital, equity accounting may be used.
Facts
In XXXXXXXXXX (USCo) wished to acquire the XXXXXXXXXX% of its shares in XXXXXXXXXX that it did not own and that were publicly held in Canada. Upon completion of this transaction, XXXXXXXXXX owned, directly and indirectly, XXXXXXXXXX% of XXXXXXXXXX.
XXXXXXXXXX made this acquisition of the XXXXXXXXXX shares for approximately $XXXXXXXXXX through a wholly owned subsidiary ("Merger"), which then merged with XXXXXXXXXX. In acquiring XXXXXXXXXX, Merger used the equity method of accounting and recorded the creation of goodwill.
Our Comments
In the Interest Deductibility Presentation to the Canadian Tax Foundation by Roy Shultis and Paul Lynch on October 1, 2002 the CCRA stated:
"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.
K. Borrowing to pay dividends
Borrowing to pay dividends is an ineligible direct use, but interest deductibility in such situations may be provided under the exceptional circumstances category, consistent with the concept of borrowing to replace capital to "fill the hole" described above. We generally accept this category of exceptional circumstances and generally accepts accumulated profits (as described in J above) as the appropriate measurement of the hole that may be filled with the borrowed money used to pay a dividend."
In our view, both the equity and the consolidated method of accounting may reflect more than the capital of the borrowing corporation and therefore would not be permitted in determining the amount of a corporation's accumulated profits for the purposes of determining the deductibility of interest.
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