Uddeholm Ltd. v. The Queen, 87 DTC 5431, [1987] 2 CTC 236 (FCTD)

Reed, J.: —The issue in this case is a very narrow one: whether the “thin capitalization rules" apply to limit the amount of interest the plaintiff can claim as an expense as against its income for the 1978 taxation year.

There is no dispute as to the purpose of subsections 18(4)* [1] to (8) of the Income Tax Act, R.S.C. 1952, c. 148 as amended. Those provisions are directed at preventing non-residents of Canada who own significant shareholdings (generally over 25 per cent), in Canadian resident corporations, from withdrawing the profits of the Canadian corporation in the form of interest payments rather than in the form of dividends paid on the shares of the corporation. I quote from page 4423 of the CCH Canadian Tax Service:

Both interest and dividends paid to non-residents are subject to withholding tax under Part XIII but since interest is, but for the limitation in subsection 18(4), deductible in computing the income of the resident corporation subject to Canadian tax, it would clearly be to a non-resident's advantage to finance the operation of a Canadian resident corporation through interest bearing debt rather than through share capital, which would lead to the establishment of thinly capitalized corporations.

There is no dispute about most of the facts. The plaintiff, Uddeholm Limited (the successor to Uddeholm Steels Limited which was the corporate entity who filed the 1978 tax return) is wholly owned by a foreign corporation, Uddeholms Aktiebolag of Sweden. Thus, the plaintiff is a corporation to which the thin capitalization rules potentially apply. There is no dispute that the equity of the corporation (retained earnings plus paid up capital) amounted to $2,537,831. The only issue is whether at any time during the year the debt owed by the plaintiff to the parent company exceeded three times its equity (ie: 3 x 2,537,831 or $9,652,302). If so then the thin capitalization rules apply and the limitation on the interest expense is proper.

The debt owed by the plaintiff to its parent has two components: a long term debt of $1,400,000 and a short term debt which varied in amount during the year. There is no dispute concerning the long term debt or the amount of interest paid with respect to it. The only dispute is whether the short term debt exceeded $8,252,302 ($9,652,302 - $1,400,000) at any time during the year. If it did, then the plaintiff fell within the scope of subsection 18(4).

The short term debt owed by the plaintiff to its parent consisted of unpaid amounts owed for product sold by the parent to the plaintiff during the year. The plaintiff was sole supplier in Canada of the parents steel products (alloyed tool steels and certain stainless steel products such as plate, bar and tubing). The short term debt varied from time to time during the year depending upon the amount of product the plaintiff purchased and when and whether such product was in fact paid for.

The parent did not charge the plaintiff any interest for the month within which product was shipped (received?). Interest charges were computed from the commencement of the following calendar month and these were accumulated from month to month as the balance outstanding was either reduced or increased. If the plaintiff had paid, during any month, some of the balance owing, the debt and corresponding interest charged therein, would thereby be reduced.

The defendant's position is that during the first six days of November, 1978, the plaintiff's debt to its parent exceeded three times equity. While the plaintiff and its parent each kept their own books and would know from day to day how much in fact was owed to the plaintiff a formal billing of the interest payable thereon was only presented to the plaintiff at four months intervals. The "faktura" for the relevant period, September to December, 1978 inclusive, shows the outstanding balances which had accumulated by the end of August and on which 12 per cent interest was calculated as owing for the month of September. It shows that same balance being carried through October to which were added the amounts outstanding as a result of the purchases made during the month of September. Thirteen per cent interest was charged for the month of October (I should note that the agreement between the plaintiff and its parent was that the interest rate charged was to be two per cent over Canadian prime). In the month of November the plaintiff started paying down the outstanding balance owing to its parent. This is reflected in the interest calculation shown on the four month "faktura". The outstanding balance at the beginning of the month (ie: that which had accrued as of the end of September together with the purchases for the month of October) amounted to $8,387,000. The "faktura" with respect to the month of November, reads in part as follows:

November, 13 /2%

April-September	7,486
October	901	8,387
8,387	1 — 6	6 days
5,387	7-22	16 days
5,212	23 - 24	2 days
4,037	25 - 27	3 days
3,962	28 - 30	3 days

The last three zeros have been dropped from the figures, but it is clear that the opening balance as of November 1 was $8,387,000. As payments were received by the parent from the plaintiff during the course of the month the outstanding balance was adjusted downward and the interest payable was correspondingly calculated by reference thereto. Thus interest for the first six days was calculated on the basis of a balance of $8,387,000; for the next 16 days it was calculated on the basis of an outstanding balance of $5,387,000 and so on.

As I understand the plaintiff's argument, it is that since there was no obligation on it to pay any amount of the interest owing for the four month period until after the plaintiff had received the "faktura" for that period, there was no outstanding debt, for the purposes of subsection 18(4), owed during that period. As I understand his argument it is that the definition of interest (paragraph 20(1 )(c) of the Income Tax Act) requires that it be an amount paid or payable with respect to a debt and since in this case the interest was not paid or payable until the end of the four month period (sometime after the end of December 1978) the $8,387,000 debt could not be said to have been outstanding during the six day period of time, November 1 to 6. It is stated that interest was not paid specifically with respect to that period of time. Instead, interest was paid by reference to the whole four month period sometime after the end of December. Counsel invites me to ignore the fluctuations during the month of November of the balance owing and to adopt a concept of average interest paid and average debt owing during the period.

I do not think I can accept the plaintiff's argument. The interest became payable as of the first day of the month following the delivery of the product. The outstanding debt was adjusted upwards or downwards as of that date depending upon the previous month's purchases. The fact that a formal accounting, as between the plaintiff and its parent, only occurred on a four month basis and that the parent did not expect any of the interest to actually be paid before that time does not change the characterization of the interest as being, payable on the debt at the first of each month and as accruing on a daily basis after that date. What is more, it does change the fact that as of November 1, 1978 the outstanding debt owed by the plaintiff to its parent was $8,387,000 plus $1,400,000 and therefore exceeded three times equity. For the reasons given the plaintiff's appeal is dismissed. The defendant shall have its costs of the action.

Appeal dismissed.