Canco 2 acquires all of the shares of Canco 3 from its parent, Canco 1, in exchange for common shares of $600 and the assumption of $400 of Canco 1 debt (the “Assumed Debt”). Canco 3’s assets are the shares of FA worth $300, and Canadian business assets worth $700. Canco 2 and Canco 3 immediately amalgamate, and Amalco immediately distributes its FA shares to Canco 1 as a return of capital. Does the interest on the Assumed Debt remain deductible?
After noting that “assumed debt can be considered to be an amount payable for property acquired,” and that “one can look to the assets of Canco 3 that become assets of Amalco in order to satisfy the purpose test under subparagraph 20(1)(c)(ii) in respect of the Assumed Debt,” the Directorate stated:
If any part of the Assumed Debt is allocable to the FA shares then, after the FA shares are distributed as a return of capital, we would likely take the position that a portion of the interest is not deductible on the basis that there would be no property substituted for the FA shares… .
However, …taking into consideration the flexible tracing approach mandated… in Ludco…as well as the comments in paragraph 1.38 of the Folio…Amalco would be entitled to allocate the entire amount of the Assumed Debt to its assets other than the FA shares. Thus, the interest payable by Amalco on the Assumed Debt would be deductible under subparagraph 20(1)(c)(ii) after the distribution of the FA shares to the extent that the remaining assets are capable of producing income from property or from a business.