Opco wishes to distribute its accumulated profits of $500,000 to its parent (Holdco) without using cash and so as to generate an interest deduction. It:
- Declares and satisfies a $500,000 dividend through the issuance of preferred shares that have a redemption amount and paid-up capital of $500,000.
- It then immediately redeems the preferred shares through its issuance to Holdco of a $500,000 interest –bearing note.
Before concluding that the interest was deductible under s. 20(1)(c)(ii), CRA referenced its position in Folio S3-F6-C1, para. 1.65 that “where a note is issued to purchase and cancel (or otherwise redeem) shares, interest expense may be deductible under subparagraph 20(1)(c)(ii),” and then stated:
In a situation as such described above where there is a capitalization of a portion of a corporation's accumulated profits as stated capital of the preferred shares of the capital stock of the corporation, the CRA is of the view that the "capital" attributable to the preferred shares for the purpose of applying the "fill the hole" concept … generally corresponds to the paid-up capital of the shares. The purpose test in subparagraph 20(1)(c) (ii) would generally be met since the Note replaces the capital that was used by Opco for eligible purposes.
Consequently, the interest on the Note could be deductible in computing Opco's income if all the conditions necessary for the application of paragraph 20(1)(c) are satisfied.