Potential embedded purpose test in s. 212(3.6)(a)(ii) (p. 12)
[A]t the 2017 IFA Conference…the Department of Finance…stated that the provision was intended to address situations where the back-to-back loan rules are "circumvented" using an instrument with a different legal character than debt. This is consistent with the 2017 BSI… . [T]he Department of Finance's 2017 IFA statement, together with the 2017 BSI, support a requirement that the character substitution rules (at least as they relate to shares) only apply where an avoidance motive has been established.
Exclusion of shareholder funding where indirect debt is higher than direct debt (pp. 13-14)
Consider an arrangement in which "Taxpayer" (a Canadian resident) owes $30 to "Forco", a non-resident (the "direct debt"). Forco (which is the "particular relevant funder" in this example) is wholly owned by "Shareholder", which has invested $10 as share capital into Forco (the "Shareholder Share Capital"). Forco is indebted to "NR Funder" in the amount of $40 (the "indirect debt"). Both the indirect debt due by Forco to NR Funder and the Shareholder Share Capital are assumed to satisfy the applicable connectedness test (under the back-to-back loan rules or character substitution rules, respectively) vis-a-vis the direct debt). …
[T]he Shareholder is deemed to be owed a nil amount under the arrangement by taxpayer because, in the above formula:
- A is the amount of direct debt (i.e., $30),
- B is the amount of indirect debt (i.e., $40),
- (A - B) is negative, and hence is deemed to be nil.
...NR Funder will be treated as the "ultimate funder" in respect of the entire amount of direct debt…
Full allocation of direct loan to shareholder equity if no indirect loan (pp. 14-15)
[Another] arrangement… is identical to the above except there is no indirect debt (for instance, the $30 direct debt may be funded entirely or at least as to $20 out of surplus funds derived from operations)….
In this example, the only funding for the direct debt which is recognized by the rules is the Shareholder Share Capital, if it should turn out that the connectedness test under the character substitution rules is satisfied, the Shareholder Share Capital will again be deemed to be a relevant funding arrangement, Shareholder will be deemed to be a relevant funder in respect of such arrangement, and the deemed relevant funding arrangement is deemed to satisfy the connectedness test under the back-to-back loan rules. However, the amount deemed to be owed to Shareholder by Taxpayer under a relevant funding arrangement is $30, because:
- A is the amount of direct debt, being $30,
- B is the amount of indirect debt, being nil,
- C and D are both equal to the amount of Shareholder Share Capital, so their ratio C/D is 1.
This leads to an arguably anomalous result, in that the Taxpayer will be deemed to have paid the full amount of actual interest to Shareholder (even though Shareholder at most funded $10/$30 = 1/3 of the direct debt)….
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