Principal Issues: 1) Deductibility of interest expense in loss consolidation scenario. 2) Tax treatment of intercorporate dividends to be paid as part of loss consolidation transactions.
Position: 1) Interest is deductible 2) Subsection 55(2) does not apply to recharacterize dividends. Dividends are deductible in computing recipients' taxable incomes and are not subject to tax under Part IV, IV.1 or VI.1.
Reasons: Intercorporate loss consolidations acceptable where parties are affiliated. Technical requirements for interest deductibility and tax treatment of intercorporate dividends are met.
XXXXXXXXXX 2008-028039
XXXXXXXXXX , 2009
Dear Sir:
Re: XXXXXXXXXX
XXXXXXXXXX
Advance Income Tax Ruling Request
We are writing in response to your letter of XXXXXXXXXX , in which you requested an advance income tax ruling on behalf of the above-noted taxpayers. We also acknowledge the information provided in subsequent correspondence and various telephone conversations. You have advised us that to the best of your knowledge and that of the taxpayers involved, none of the issues involved in this ruling request are:
(i) in an earlier return of the taxpayers or persons related to the taxpayers;
(ii) being considered by a tax services office ("TSO") or taxation centre ("TC") in connection with a previously filed tax return of the taxpayers or persons related to the taxpayers;
(iii) under objection by the taxpayers or persons related to the taxpayers;
(iv) before the courts; or
(v) the subject of a ruling previously issued by the Income Tax Rulings Directorate.
Unless otherwise noted, all statutory references herein are to the Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.), as amended (hereinafter referred to as the "Act"). Unless otherwise noted, all references to currency are to Canadian dollars.
DEFINITIONS
(a) "adjusted cost base" has the meaning assigned by section 54;
(b) "affiliated persons" has the meaning assigned by subsection 251.1(1);
(c) "arm's length" has the meaning assigned by subsection 251(1);
(d) "Canadian-controlled private corporation" has the meaning assigned by subsection 125(7);
(e) XXXXXXXXXX ;
(f) "CRA" means Canada Revenue Agency;
(g) "First Subco Loan" means the first loan made to Subco in the amount of $XXXXXXXXXX by financial institutions that deal at arm's length with Subco, as described in Paragraph 11;
(h) "Newco" means the subsidiary wholly-owned corporation of Parentco, to be incorporated as described in Paragraph 8;
(i) "Newco Preferred Shares" means the preferred shares of by Newco described in Paragraph 9;
(j) "paid-up capital" has the meaning assigned by subsection 89(1);
(k) "Paragraph" means a numbered paragraph in this letter;
(l) "Parent Debt" means loans made to Parentco by financial institutions that deal at arm's length with Parentco in connection with the acquisition by Parentco of investments in securities which trade on public stock exchanges;
(m) "Parent Preferred Shares" means the preferred shares of by Parentco described in Paragraph 10;
(n) "Parentco" means XXXXXXXXXX ., a taxable Canadian corporation and a Canadian controlled private corporation incorporated under the XXXXXXXXXX, whose address is XXXXXXXXXX , whose Canadian federal income tax returns are filed with the XXXXXXXXXX Tax Centre, whose Canadian federal income tax affairs are administered by the XXXXXXXXXX Tax Services Office and whose taxation year ends on XXXXXXXXXX ;
(o) "Proposed Transactions" means the transactions described in Paragraphs 8 to 17;
(p) "public corporation" has the meaning assigned by subsection 89(1);
(q) "related persons" has the meaning assigned by section 251;
(r) "Subco" means XXXXXXXXXX , a taxable Canadian corporation and a Canadian controlled private corporation incorporated under the XXXXXXXXXX , whose address is XXXXXXXXXX , whose Canadian federal income tax returns are filed with the XXXXXXXXXX Tax Centre, whose Canadian federal income tax affairs are administered by the XXXXXXXXXX Tax Services Office and whose taxation year ends on XXXXXXXXXX ;
(s) "Subco Debt" means the First Subco Loan and the Subsequent Subco Loans;
(t) "Subsequent Subco Loans" means the loans made to Subco following the First Subco Loan, as described in Paragraph 15;
(u) "taxable Canadian corporation" has the meaning assigned by subsection 89(1); and
(v) "taxable dividend" has the meaning assigned by subsection 89(1).
FACTS
1. Subco has significant operations in the XXXXXXXXXX industries. Parentco holds portfolio investments, real estate investments and provides management services to its subsidiaries, including Subco. All business operations carried on directly by Subco and Parentco are carried on within Canada; subsidiaries of Subco and Parentco carry on business activities outside of Canada.
2. Subco has authorized share capital of XXXXXXXXXX Class A preferred shares, XXXXXXXXXX Class B preferred shares and XXXXXXXXXX common shares, of which XXXXXXXXXX Class A preferred shares and XXXXXXXXXX common shares are issued and outstanding. Parentco holds all of the issued and outstanding shares of Subco.
3. Parentco has authorized share capital of XXXXXXXXXX common shares of which XXXXXXXXXX are issued and outstanding. All of the issued and outstanding shares of Parentco are held by XXXXXXXXXX , a corporation incorporated under the XXXXXXXXXX . XXXXXXXXXX is controlled by XXXXXXXXXX , a Canadian-resident individual. The shares of XXXXXXXXXX are held by XXXXXXXXXX , children of XXXXXXXXXX and XXXXXXXXXX family trusts established for the benefit of persons related to XXXXXXXXXX .
4. Parentco controls Subco. There are no unanimous shareholders agreements or similar arrangements in force among the shareholders of Parentco or Subco that (i) restrict, in whole or in part, the powers of the directors of Parentco or Subco to manage the business and affairs of each respective corporation or (ii) affect the power of any shareholder of Parentco or Subco to control the election of the board of directors of the respective corporations.
5. The Parent Debt is approximately $XXXXXXXXXX . The Parent Debt relates to money borrowed by Parentco to fund the acquisition of publicly-traded securities.
6. The interest expense on the Parent Debt has been deducted by Parentco in computing its income for the purposes of the Act. As a consequence of deducting the interest expense on the Parent Debt, Parentco is estimated to have $XXXXXXXXXX of non-capital losses as at XXXXXXXXXX , with a non-capital loss of $XXXXXXXXXX arising in its XXXXXXXXXX taxation year and a non-capital loss of $XXXXXXXXXX estimated to arise in the XXXXXXXXXX taxation year.
7. Based on current agreements in place with Canadian chartered banks, Parent and Subco can borrow in excess of $XXXXXXXXXX from Canadian chartered banks in addition to the outstanding borrowings of Parentco and Subco without contravening current borrowing agreements, including the default of any bank covenants. In a letter XXXXXXXXXX has confirmed that Subco has available credit of approximately $XXXXXXXXXX on a $XXXXXXXXXX operating line of credit provided by XXXXXXXXXX . As of the date of this letter, the available balance on that operating line of credit is approximately $XXXXXXXXXX . Parentco has also drawn upon an investment line of credit to create the Parent Debt. Subco is also able to draw upon this credit facility to the extent of any available balance.
PROPOSED TRANSACTIONS
8. A new corporation, Newco, will be incorporated under the XXXXXXXXXX . Newco will be a taxable Canadian corporation. The taxation year of Newco will end on XXXXXXXXXX . Newco's activities will be limited to the transactions described herein including investing the proceeds received, upon issuance of Newco Preferred Shares to Subco, in Parent Preferred Shares, as described in Paragraph 13.
9. The authorized share capital of Newco will consist of two classes of shares, common shares and Newco Preferred Shares. Newco will issue common shares to Parentco for a subscription price of $XXXXXXXXXX . The Newco Preferred Shares will be non-voting, will bear cumulative dividends and will have a redemption amount and retraction price equal to their subscription price. The dividends payable on the Preferred Shares will be calculated, on an annual basis, as a percentage of the redemption amount and retraction price of the Preferred Shares. The dividend rate payable on the Preferred Shares will exceed the rate of interest payable on the Subco Debt.
10. Parentco will amend its articles of incorporation to create a new class of preferred shares ("Parent Preferred Shares"). The Parent Preferred Shares will be non-voting, will bear cumulative dividends and will have a redemption amount and retraction price equal to their subscription price. The dividends payable on the Parent Preferred Shares will be calculated by reference to the redemption amount and retraction price of the Preferred Shares with a rate equal to the dividend rate on the Newco Preferred Shares.
11. Subco will borrow the amount of $XXXXXXXXXX (the "First Subco Loan") using the existing credit facilities referred to in Paragraph 7.
12. Subco will use the total amount of the proceeds from the First Subco Loan to subscribe for Newco Preferred Shares having an equivalent fair market value, which will also be the aggregate redemption amount and retraction price of such Newco Preferred Shares.
13. Newco will use the total amount of the proceeds from the Newco Preferred Share subscription to subscribe for Parent Preferred Shares having an equivalent fair market value, which will also be the aggregate redemption amount and retraction price of such Parent Preferred Shares. Newco is permitted to hold shares of Parent under applicable corporate laws.
14. Parentco will repay a portion of the Parent Debt with the proceeds received from the issuance of Parent Preferred Share to Newco.
15. Upon repayment of the portion of the Parent Debt described in Paragraph 14, Subco will have the ability to borrow, under credit facilities described in Paragraph 7, the amount repaid by Parentco. That is, as Parentco repaid $XXXXXXXXXX of the Parent Debt after Subco borrowed an equivalent amount, Parentco and Subco will have the borrowing capacity that existed at the commencement of the Proposed Transactions. Subco will continue to borrow tranches of $XXXXXXXXXX ("Subsequent Subco Loans") under the existing credit facilities described in Paragraph 7, with the last tranche adjusted to the amount required to extinguish the Parent Debt if such amount is less than $XXXXXXXXXX . The funds so borrowed on each tranche will be used in the same manner, by the same parties, and for the same purposes, as described in Paragraphs 12 to 14 in connection with the First Subco Loan. For each tranche, the transactions in Paragraphs 12 to 14 will be repeated in sequence until the Parent Debt has been fully repaid by Parentco, at which point the principal amount of the Subco Debt will be equal to the principal amount of the Parent Debt immediately prior to the commencement of the Proposed Transactions.
16. On an annual basis, Parentco will pay dividends on the Parent Preferred Shares to Newco.
17. Upon receipt by Newco of dividends received on the Parent Preferred Shares, Newco will pay dividends on the Newco Preferred Shares to Subco.
OTHER INFORMATION
18. The amount of the Subco Debt will be guaranteed by Parentco and, specifically, by the investments held by Parentco.
19. Based on financial projections, Subco will have the financial capacity to pay the interest on the Subco Debt from its own cash flow, which includes the dividends received on the Newco Preferred Shares. Parentco will have the capacity to fund the payment of dividends to Newco on the Parent Preferred Shares from sources of income other than the shares of Subco held by Parentco.
20. The Newco Preferred Shares and Parent Preferred Shares will not be, at any time during the implementation of the Proposed Transactions described herein:
(a) the subject of any undertaking that is referred to in subsection 112(2.2) of as a "guarantee agreement";
(b) the subject of a dividend rental arrangement as that term is defined in subsection 248(1);
(c) the subject of any secured undertaking of the type of described in paragraph 112(2.4)(a); or
(d) issued for consideration that is or includes:
(i) an obligation of the type described in subparagraph 112(2.4)(b)(i), other than an obligation of a corporation that is related (otherwise than by reason of a right referred to in paragraph 251(5)(b)); or
(ii) any right of the type described in subparagraph 112(2.4)(b)(ii).
21. The credit facilities that comprise the Parent Debt, including the credit facilities that Subco will draw upon as described in Paragraphs 11 and 15, do not contain any features that would allow the lender to acquire equity interests in Parentco or Subco or allow the lender to exchange indebtedness for shares of Parentco or Subco, nor do such facilities contain any features that track the value of any equity interests in Parentco or Subco.
22. In the event Subco has non-capital losses for any taxation years in which it may deduct interest payable on the Subco Debt in computing its income, no amount in respect of such non-capital losses will be deducted by Subco in computing its taxable income for a taxation year ending after the end of the last taxation year of Parentco in which the non-capital loss for Parentco's XXXXXXXXXX taxation year, described in Paragraph 6, may be deducted in computing Parentco's taxable income in accordance with paragraph 111(1)(a).
PURPOSE OF THE PROPOSED TRANSACTIONS
23. The purpose of the Proposed Transactions is to allow for consolidation of profit and losses between Parentco and Subco. The consolidation will be achieved through the reduction of Parentco's interest expense, which, in the absence of the
Proposed Transactions, would create non-capital losses in Parentco's current taxation year and in its future years due to the amount of income currently being and expected to be earned by Parentco. Further, the Proposed Transactions will allow Subco to reduce its anticipated taxable income by an equivalent amount in the form of interest expense payable by it on the Subco Debt.
24. Overall, the Proposed Transactions serve to replace existing third-party debt with new third-party debt. That is, the transactions allow Parentco to repay its third-party debt and allow Subco to borrow an equal amount of new third-party debt. The total debt owing to third parties will be the same after the Proposed Transactions as it is before the Proposed Transactions. As stated above, the Proposed Transactions allow the interest expense to be incurred by Subco rather than Parentco.
RULINGS
Provided that the preceding statements constitute a complete and accurate disclosure of all of the relevant facts, proposed transactions, other information and the purposes of the Proposed Transactions, and provided further that the Proposed Transactions are completed in the manner described above, we rule as follows:
A. Provided that Subco has a legal obligation to pay interest on the Subco Debt, and the Newco Preferred Shares described in Paragraphs 9 and 12 continue to be held by Subco, Subco will be entitled pursuant to paragraph 20(1)(c) to deduct the lesser of (i) the interest paid or payable (depending on the method regularly followed by Subco in computing its income for purposes of the Act) in respect of the year on the Subco Debt or (ii) a reasonable amount in respect thereof.
B. The dividends received by Subco and Newco, described in Paragraphs 16 and 17, respectively, will be taxable dividends that will, pursuant to subsection 112(1), be deductible in computing the taxable income of Subco and Newco, as the case may be, for the year in which the dividend is received, and, for greater certainty, such deduction will not be precluded by any of subsections 112(2.1), 112(2.2), 112(2.3) and 112(2.4).
C. The dividends described in Ruling B will not be subject to tax under Part IV, except as provided in paragraph 186(1)(b).
D. The dividends described in Ruling B will not be subject to tax under Part IV.1 or VI.1.
E. Provided that there is no disposition or increase in interest described in any of subparagraphs 55(3)(a)(i) to (v) as part of a series of transactions or events that includes the Proposed Transactions, then by virtue of paragraph 55(3)(a), the provisions of subsection 55(2) will not apply to the taxable dividends described in Ruling B. For greater certainty, the Proposed Transactions described herein, in and by themselves, will not be considered to result in any disposition or increase in interest described in any of subparagraphs 55(3)(a)(i) to (v).
F. The provisions of subsections 15(1) and 246(1) will not be applied as a result of the Proposed Transactions, in and by themselves.
G. Subsection 245(2) will not apply to the Proposed Transactions, in and by themselves, to re-determine the tax consequences confirmed in the rulings given.
These rulings are given subject to the limitations and qualifications set forth in Information Circular 70-6R5 issued on May 17, 2002, and are binding on the CRA provided that the Proposed Transactions are completed on or before XXXXXXXXXX .
The above rulings are based on the Act in its present form and do not take into account any proposed amendments to the Act, which if enacted, could have an effect on the rulings provided herein.
COMMENTS
In addition, nothing in this letter should be construed as implying that the CRA has agreed to or reviewed:
(a) the determination of the adjusted cost base, paid-up capital or fair market value of any shares or other property referred to herein; and
(b) the amount of non-capital losses of Parentco;
(c) the provincial income tax implications relating to the allocation of income and expenses under the Proposed Transactions;
(d) the application or non-application of the general anti-avoidance provisions of any province; or
(e) any tax consequences relating to the facts and Proposed Transactions described herein other than those described in the rulings given above.
Yours truly,
for Division Director
Reorganizations and Resources Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
