Principal Issues: Whether the interest is deductible under 20(1)(c) (fill in the hole concept) in the situation (stock dividend with preferred shares, amount of dividend is less than accumulated profits of corporation, stated capital of preferred shares is equal to their FMV and redemption price, and a note issued on the redemption of the preferred shares) described in the letter?
Position: Yes.
Reasons: Folio S3-F6-C1 and jurisprudence.
XXXXXXXXXX 2014-052725 R. Gagnon May 26, 2016
Dear Madam,
Subject: Paragraph 20(1)(c) of the Act
This is in response to your letter of April 8, 2014 in which you asked for our opinion regarding the application of paragraph 20(1)(c) of the Income Tax Act (the" Act") with regard to the situation as described below. We apologize for the response time.
Unless otherwise indicated, all statutory references herein are to the provisions of the Act.
Our understanding of the situation described in your letter is as follows.
Facts and Assumptions
1. Opco and Holdco are taxable Canadian corporations (within the meaning of the definition in subsection 89(1)).
2. Holdco holds all of the issued and outstanding shares of the capital stock of Opco.
3. Accumulated profits (within the meaning of paragraphs 1.48, 1.50 and 1.51 of Income Tax Folio S3-F6-C1, Interest Deductibility ("Folio S3-F6-C1")) and retained earnings of Opco exceed $500,000. The accumulated profits retained by Opco were used by Opco to earn income from a business or property.
4. Opco intends to pay a $500,000 dividend to Holdco, but does not have the funds to pay the dividend in cash. Opco wishes to issue an interest-bearing note to Holdco on which interest would be deductible in computing its income pursuant to paragraph 20(1)(c).
5. Opco will declare a $500,000 dividend to Holdco. The dividend will be paid immediately in preferred shares of its capital stock ("Preferred Shares"), whose fair market value, redemption price, amount added to stated capital (as determined under the applicable corporate law) and paid-up capital (as defined in subsection 89(1)) will each be $500,000. The Preferred Shares will be redeemable at the option of the holder and of the corporation.
6. Opco's retained earnings will thereby be reduced by $500,000.
7. Opco will then immediately redeem the Preferred Shares for their $500,000 redemption price and issue as consideration a promissory note ("Note") that is payable on demand, bears interest, and whose principal amount will correspond to the total redemption price of the Preferred Shares. The interest payable on the Note will be reasonable for the purpose of applying paragraph 20(1)(c).
Question
In the situation described above, would the interest payable by Opco to Holdco on the Note be deductible by Opco in computing its income under subparagraph 20(1)(c)(ii) (subject to satisfying the rules set out in paragraph 23 of Interpretation Bulletin IT-533)?
Our Comments
This technical interpretation provides general comments on the provisions of the Act. It does not confirm the income tax treatment of a particular situation involving a particular taxpayer, but rather is intended to assist you in making that determination. Our Directorate only confirms the tax treatment of particular transactions of a particular taxpayer in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R7, Advance Income Tax Rulings and Technical Interpretations.
Interpretation Bulletin IT-533, "Interest Deductibility and Related Issues" has been cancelled by the CRA and replaced by Folio S3-F6-C1, which is available on the CRA's website.
The CRA states the following in paragraph 1.65 of its Folio S3-F6-C1:
Note issued to redeem shares
1.65 Where a note is issued to purchase and cancel (or otherwise redeem) shares, interest expense may be deductible under subparagraph 20(1)(c)(ii) to the extent of the interest on the amount of the note issued. Any deduction must be within the limits described in ¶1.48 and 1.49. This is consistent with the decision in Penn Ventilator Canada Ltd. v The Queen, [2002] 2 CTC 2636, 2002 DTC 1498 (TCC). …
In the situation described above, there is a redemption of shares, and therefore it appears to us that the CRA's position referred to in paragraph 1.65 of Folio S3-F6-C1 is applicable.
In a situation such as 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 (as described in paragraphs 1.45 and 1.48 of Folio S3-F6-C1) 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.
In closing, please note that the purpose of the question was to obtain our opinion on the application of paragraph 20(1)(c) and that our comments are limited to that aspect of the question.
We hope that our comments are of assistance.
Stéphane Charette, CPA, CMA, MBA
for the Director
Reorganizations Division
Income Tax Rulings Directorate
Legislative Policy
and Regulatory Affairs Branch