29 November 2000 Internal T.I. 2000-0051367 - INTEREST ON REDEMPTION OF SHARES

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

Deductibility of interest.

Position TAKEN:

Interest would not be deductible for a portion of the expense.

Reasons FOR POSITION TAKEN:

Interest is deductible on loan to redeem shares up to PUC and accumulated profits..

		November 29, 2000

	TORONTO NORTH TSO					HEADQUARTERS
	Compliance Program Division					Yves Leclerc
(613)  957-2744
Attention:  B. Friedman
									2000-005136

XXXXXXXXXX

We are writing in response to your request for our views with respect to the deductibility of interest in a case that is presently being audited. The particulars of the case have been sent to our office in a memorandum dated October 16, 2000 outlining the situation to be considered.

In summary, the situation under consideration is as follows:

XXXXXXXXXX

In your opinion, as a material portion of the judgrnent pertains to the redemption of capital, i.e. XXXXXXXXXX%, it is your intention to propose to disallow that portion of the interest paid and expensed by the taxpayer. In your view, the interest expense is on account of capital (paragraph 18(1)(b)) and not incurred for the purpose of earning income from that business or property. Thus your proposal to the taxpayer would be to disallow $XXXXXXXXXX of the pre-judgement interest, post judgement interest and bank loan interest during the audit period.

Analysis

Subparagraph 20(1)(c)(i) of the Act allows a deduction for interest on money borrowed for the purpose of earning income from a business or property. Subparagraph 20(1)(c)(ii) refers to interest paid or payable in respect of the year on "an amount payable for property acquired for the purposes of gaining or producing income therefrom". In this particular case, there has been no property acquired by the corporation upon the redemption of its shares, thus the interest on the debt is not deductible pursuant to subparagraph 20(1)(c)(ii).

With respect to borrowing funds for the purpose of redeeming shares, the leading jurisprudence is Trans-Prairie Pipelines Ltd. v. Minister of National Revenue (70 DTC 6351). That case dealt with a company that redeemed its preferred shares for $700,000 in order to raise further capital by means of bond issues. Trans Prairie used part of the funds received from issuing bonds to redeem its preferred shares. The Minister disallowed a deduction for interest on that portion of the bonds, on the basis that it was not used for the purpose of earning income. The court held that the whole of the borrowed money was used for the purpose of earning income since it went to fill the gap left by the redemption. The court also held that what is important in such matters is not whether the funds are still being used for the original purpose for which they were borrowed, but whether they are being used in the present taxation year in order to earn income.

As well, in the case of The Queen v. Bronfman (87 DTC 6351), Trans-Prairie Pipeline Ltd. was cited as an exception to the requirement for an eligible direct use as follows:

"With the exception of Trans-Prairie, then, the reasoning of which is, in my opinion, inadequate to support the conclusion sought to be reached by the respondent Trust, the jurisprudence has generally been hostile to claims based on indirect, eligible uses when faced with direct but ineligible uses of borrowed money."

In addition, the Agency's position is stated in the Interpretation Bulletin IT-80 as follows:

"Redemption of Shares

2. One of the requirements of paragraph 20(1)(c) is that the borrowed money in respect of which the interest expense was incurred must have been "... used for the purpose of earning income from a business or property...". Because of this requirement, interest expense has been disallowed where it was in respect of money borrowed to redeem shares of a corporation on the grounds that the borrowed money was not, in fact, used to earn income from the business but rather was paid out to the shareholders to redeem their shares.

3. The Exchequer Court decided, however, in the Trans-Prairie Pipelines Ltd. case that the alternative and preferred view of this type of transaction was that, in essence, the borrowed money replaced the money that was originally obtained from the issuance of the preferred shares. Having adopted this view, the Court decided that interest on the borrowed money was deductible if the money that it was considered to replace was being used to earn income from the business.

4. This decision has been accepted by the Department. Therefore, in circumstances as described in the above paragraph, interest expense which is otherwise deductible under paragraph 20(1)(c) will not be disallowed because the borrowed funds were used to redeem shares. "

Lastly, a more recent court case confirmed the Agency's position in Livingston International Inc. (91 DTC 607), which was confirmed by the Federal Court of Appeal (92 DTC 6197). It stated that the interest is deductible to the extent of the PUC of the shares redeemed and its accumulated profits.

Thus, to the extent of the paid up capital of the shares redeemed, interest on that portion of the borrowed money used to redeem the shares is deductible (assuming of course that the capital was being used in the business of XXXXXXXXXX).

However, the portion of the prejudgement and post judgement interest that is related to the amount payable for the redemption of the shares is not interest on borrowed money thus it would not meet the requirements of subparagraph 20(1)(c)(i) of the Act.

In the Income Tax Technical News # 3, the Agency's view on a promissory note issued as consideration for the redemption or purchase for cancellation of a corporation's capital stock is as follows:

"It is the Department's view that the interest payable on a promissory note issued as consideration for the redemption or purchase for cancellation of a corporation's capital stock is not deductible under paragraph 20(1)(c). The basis for this view is that since the note does not constitute "borrowed money", subparagraph 20(l)(c)(i) is inapplicable and the administrative position outlined in IT-80 would not be available. Secondly, the note is not an amount payable for property acquired by the corporation to earn income from its business or from the shares so acquired and therefore subparagraph 20(1)(c)(ii) is also inapplicable."

Conclusion

With respect to the interest allocated to XXXXXXXXXX corporation for the time lapse between his departure and the final redemption of the shares, there was no property acquired for the purpose of gaining or producing income and the interest was not accruing on borrowed money used for the purpose of earning income before the shares were redeemed. Therefore, the pre and post judgment interest related to the amount payable for the redemption of the shares. would not be deductible under 20(1)(c)(i) or (ii) of the Act.

The interest expense incurred on the portion of the bank loan that was used to pay the redemption amount of the shares is deductible under subparagraph 20(1)(c)(i), in accordance with the jurisprudence and IT-80 to the extent that the funds are used to return capital on the shares. In the present case, since there is no accumulated profit, the PUC of the shares redeemed should be considered as a basis for the deduction of interest paid on that portion of the $XXXXXXXXXX borrowed in XXXXXXXXXX that was used to pay the balance owing on the share redemption.

We do not disagree with your proposal to allow a deduction for interest referable to the $XXXXXXXXXX that was paid as a bonus.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Legislation Access Database (LAD) on the Canada Customs and Revenue Agency's mainframe computer. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the LAD version, or they may request a copy severed using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Mrs. Jackie Page at (613)994-2898. A copy will be sent to you for delivery to the client.

We trust that this is the information which you require.

for Director
Financial Industries Division
Income Tax Rulings Directorate