Novopharm Ltd. v. Canada, 2003 DTC 5195, 2003 FCA 112 -- summary under Paragraph 20(1)(c)

A profitable Canadian corporation ("Novopharm") acquired losses approximating $20 million of an arm's-length corporation ("Lossco") through a complicated series of transactions, which in simplified form were as follows:

1. two special-purpose subsidiaries of Lossco formed a limited partnership ("Millbank") which borrowed $195 million from First Marathon Capital Corporation ("FMCC") and lent $195 million to First Marathon Inc. ("FMI") with FMI then immediately paying $20 million to Millbank as a prepayment of one year's interest and Millbank utilizing $20 million to pay down the principal of loan owing by it to FMCC to $175 million;
2. Lossco acquired a 99.99% limited partnership in Millbank shortly thereafter (and immediately prior to the first fiscal year end of Millbank) thereby resulting in $20 million of income of Millbank being allocated to it, which eliminated its losses;
3. the 99.99% partnership interest was transferred for nominal consideration by Lossco to an indirect special purpose subsidiary of Lossco ("540") and 540 then was sold to Novopharm;
4. FMCC lent $175 million to Novopharm which used those proceeds to subscribe for shares of 540; 540 made a capital contribution of the same amount to Millbank, which paid off the $175 million loan owing by it to FMCC;
5. a year later after $20 million of interest had accrued on the loan owing by Novopharm to FMCC, FMI repaid the $195 million principal amount owing by it to Millbank, Millbank distributed this sum to its partners (substantially 540), 540 purchased for cancellation most of the shares of Novopharm and 540 for $195 million (giving rise to a deemed dividend of $20 million), and Novopharm used the $195 million to discharge the amount owing by it to FMCC (including the $20 million of interest).

The borrowing by Novopharm to acquire shares of 540 (step 4) gave rise to deductible interest (before giving effect to former s. 245(1)) because the redemption of the shares gave rise to a deemed dividend (step 5). Rothstein J.A. stated (at p. 5200):

"The fact that the dividend received by Novopharm was a deemed dividend pursuant to subsection 84(3) is of no consequence. A deeming provision is a statutory fiction that replaces or modifies reality; and it cannot be ignored."