9120235 24(1)
Dear Sirs:
We are writing in response to your letter dated July 17, 1991 wherein you requested certain technical interpretations regarding the deductibility of certain interest expenses under the proposed amendments announced in the Notice of Ways and Means Motion (hereinafter referred to as the "Motion") to amend the Income Tax Act (Canada) (the "Act") released on December 20, 1990 in the following hypothetical situation.
A taxpayer, Mr. X owned all of the issued and outstanding shares of XCo. until 1988 when Mr. X transferred the shares of XCo. to Holdco, an Ontario corporation. At the time of the transfer, the shares of XCo. had an adjusted cost base and paid-up capital of $100 and a fair market value of $1,000. Mr. X and Holdco jointly elected under subsection 85(1) of the Act that the proceeds of disposition to Mr. X and the cost to Holdco of the shares of XCo. be deemed to be $100. Pursuant to subsection 24(3) of the Business Corporations Act, 1982 (Ontario) (the "BCA"), Holdco added $100 to its stated capital account in respect of the shares issued in consideration for the shares of XCo. For accounting purposes, the $900 difference between the $1,000 fair market value of the shares of XCo. and the $100 added to the stated capital account of Holdco was added to contributed surplus. All of the assets of XCo. were used for a qualifying purpose within the meaning of section 1(a) of the Motion.
Situation 1
If XCo. paid a dividend to Holdco, you would like us to confirm that the dividend would be included in Holdco's accumulated profits and deducted from XCo.'s accumulated profits?
Situation 2
If Holdco incurred a $200 loss for accounting purposes in 1988 (e.g., because it began to carry on a business) and in 1989 applied $200 of contributed surplus against the resulting deficit in accordance with section 3250.11 of the CICA Handbook, would we consider Holdco to have accumulated profits of $300 if it subsequently earned $300 of income for accounting purposes or would we consider the accumulated profits to be only $100 (because the application of $200 of contributed surplus to the deficit is to be ignored in calculating accumulated profits)?
Situation 3
If Holdco borrowed $999 in 1988 immediately after the acquisition of the shares of XCo. in order to redeem 99.99% of its outstanding shares and had no retained earnings at such time, would we consider that the $900 of contributed surplus constituted "capital" as that term is used in paragraph 2(b)(i) of the Motion or is "capital" considered to mean "paid-up capital" as defined in paragraph 89(1)(c) of the Act?
In your letter you have outlined what appears to be an actual fact situation related to a completed transaction. The review of such transactions falls within the responsibility of District Taxation Offices and it is the practice of this Department not to comment on such transactions when the identities of the taxpayers are not known. However, we can provide you with the following general comments which we hope will be of assistance to you.
The Department's general position regarding the deductibility of interest on money borrowed to redeem shares or to pay dividends is reflected in Interpretation Bulletin IT-80. It is the Department's interpretation that the term "accumulated profits" as expressed in subparagraph 1(a)(i) of the Motion and paragraph 5 of IT-80 generally means retained earnings computed in accordance with Canadian generally accepted accounting principles, except that the computation:
(a) is made on an unconsolidated basis with investments accounted for on a cost basis; and
(b) does not include any appraisal surplus or profits resulting from non-arm's length transactions which transform appraisal surplus into profits on a non- taxable or tax-deferred basis.
Where a parent corporation receives a dividend out of a subsidiary's accumulated profits, we are of the view that the parent corporation's accumulated profits would be increased by the amount of the dividend received by it and the subsidiary's accumulated profits would be reduced by the amount of the dividend paid by it.
The Department is of the view that a corporation's contributed surplus, resulting from non-arm's length transactions which effectively transform appraisal surplus into profits, and which has been applied against the corporation's deficit in accordance with section 3250.11 of the CICA Handbook would not be included in the calculation of the particular corporation's accumulated profits.
It is the Department's position that the term "capital", as it is used in relation to any deduction of interest on money borrowed, generally refers to the accounting concept of that term and will include contributed surplus where it arises as a result of assets having been acquired from an arm's length vendor. Where a corporation's contributed surplus results from a non-arm's length acquisition of assets, it would not be included in the corporation's capital for purposes of determining the amount of interest which may be deductible pursuant to the Motion.
The foregoing comments represent our general views with respect to the subject matter of your letter. The facts of a particular situation may lead to different conclusions. The foregoing opinions are not rulings and, in accordance with the guidelines set out in Information Circular 70-6R2 dated September 28, 1990, are not binding on the Department.
Yours truly,
for DirectorReorganizations and Foreign DivisionRulings DirectorateLegislative and Intergovernmental Affairs Branch