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 CCRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.
Principal Issues:
Purchaseco acquires the shares and non-trade commercial debt of Targetco for cash and a promissory note. (Purchase Note). Following the acquisition, Purchaseco and Targetco would amalgamate to form Amalco.
1. Would the interest payable on the Purchase Note be deductible to Purchaseco with the meaning of paragraph 20(1)(c) of the Act?
2. If the answer to #1 is yes, would the interest payable on the Purchase Note continue to be deductible to Amalco within the meaning of paragraph 20(1)(c) of the Act, and consistent with the Department's position in Interpretation Bulletin IT-315?
3. After the amalgamation of Purchaseco and Targetco, would subsection 80.01(3) of the Act apply to override subsection 80.01(8)
Position TAKEN:
1. Question of fact. General comments provided.
2. Question of fact. General comments provided.
3. General comments provided on subsections 81.01(3) and (8).
Reasons FOR POSITION TAKEN:
1. 2002 CTF
2. 2002 CTF
3. Wording in subsections 80.01(3) and (8)
XXXXXXXXXX 2002-012138
G. Moore
March 5, 2003
Dear XXXXXXXXXX:
Re: Paragraph 20(1)(c) and subsection 80.01(3) of the Income Tax Act (the "Act")
This is in reply to your correspondence of January 31, 2002, in which you describe a particular fact situation and ask for our interpretation concerning the application of the above-noted provisions.
The situation you describe is as follows:
Purchaseco, a taxable Canadian corporation, would be formed to purchase Targetco. Purchaseco would purchase all of the issued and outstanding common shares and all of the outstanding indebtedness of Targetco owing to its shareholder. The agreed purchase price paid for Targetco is allocated as $1.00 for the common shares and the balance for the indebtedness ("Target Note") owing by Targetco. The consideration for the purchase price of Targetco would be an interest-bearing promissory note ("Purchase Note").
The Target Note is non-interest bearing and is a commercial obligation within the meaning of subsection 80(1) of the Act. The specified cost of the Target Note would exceed 80% of the principal amount of the obligation for purposes of subsection 80.01(8) of the Act.
Following the acquisition of the common shares and the Target Note, Targetco would be a wholly-owned subsidiary of Purchaseco. Purchaseco would amalgamate with Targetco pursuant to subsection 87(1) of the Act. There would be no changes to the shareholdings of Purchaseco following the amalgamation.
Question #1
Would the interest payable on the Purchase Note be deductible to Purchaseco within the meaning of paragraph 20(1)(c) of the Act?
Question #2
If the answer to #1 is yes, would the interest payable on the Purchase Note continue to be deductible to Amalco within the meaning of paragraph 20(1)(c) of the Act, and consistent with the Department's position in Interpretation Bulletin IT-315?
Question #3
After the amalgamation of Purchaseco and Targetco, would subsection 80.01(3) of the Act apply to override subsection 80.01(8) of the Act such that the excess of the principal amount of the Target Note over the specified cost of the Target Note would be a forgiven amount within the meaning of subsection 80(1) of the Act?
The particular situation outlined in your letter apears to relate to a factual one, involving a specific taxpayer. As explained in Information Circular 70-6R5, it is not this Directorate's practice to comment on proposed transactions involving specific taxpayers other than in the form of an Advance Income Tax Ruling. Should your situation involve a specific taxpayer and a completed transaction, you should submit all relevant facts and documentation to the appropriate Tax Services Office for their views. However, we are prepared to offer the following general comments which may be of assistance.
1. Subparagraph 20(1)(c)(i) of the Act allows a deduction for interest on borrowed money used for the purpose of earning income from a business or property. On October 1, 2002, we presented at the Canadian Tax Foundation an update on our preliminary review of our existing interpretative and administrative positions on interest deductibility. One of these positions related to the deductibility of interest with respect to money borrowed to purchase common shares. The primary issue is the income earning purpose of the share acquisition. The purpose test is applied as follows: Considering all the circumstances, did the taxpayer have a reasonable expectation of income at the time the investment was made (absent a sham, window dressing or other vitiating circumstances). Normally, we consider interest costs in respect of funds borrowed to purchase common shares to be deductible on the basis that there is a reasonable expectation (at the time the shares are acquired) that the common shareholder will receive dividends. However, it is conceivable that in certain fact situations, such reasonable expectation would not be present. Where evidence from corporate officials indicates that dividends are not expected to be paid and that shareholders are required to sell their shares in order to realize their value, the purpose test would likely not be met. Where a corporation is silent with respect to its dividend policy, or where the dividend policy is that dividends will be paid when operational circumstances permit, the purpose test will likely be met. However, each situation must be dealt with on the basis of the particular facts involved.
When a loan is interest-free, the direct use of the borrowed money is ineligible since no income can be generated from the property acquired. Thus, interest on borrowed money to acquire such property is generally not deductible; however, in certain factual situations, a deduction may be available under the exceptional circumstances category. No comprehensive guidelines can be provided as to when such a borrowing would qualify. However, we would generally accept the deduction of interest on borrowed money used to make an interest-free loan to a wholly-owned corporation (or in cases of multiple shareholders, where each shareholder makes an interest-free loan in proportion to their shareholders) where the proceeds will be used by the corporation to produce income, thereby increasing the potential dividends to be received. Interest deductibility in other situations may be warranted depending upon the particular facts of a given situation.
2. As you know, in a typical leveraged buy-out, borrowed money is initially used to acquire common shares of the target company and interest on that borrowed money would generally be deductible pursuant to our interpretation on common shares. After acquisition of the target company, the purchaser is amalgamated with, or winds-up, the target company. In Ludco, the Supreme Court reinforced the current use/tracing principle in Tennant and extended it with reference to a flexible approach to establishing a link. It is our view that this approach would allow the establishment of a link for the current use of the borrowed money between the shares that were initially acquired and the assets formerly held by the corporate target that are now owned by the initial corporate borrower. There is no arm's length requirement in establishing such a link. In the situation you described, if all of the conditions are met, then the position described above will apply.
3. In a debt parking situation, the requirements of subsection 80.01(8) of the Act must exist in order for the debt to be deemed to be settled. The preamble stipulates two conditions for considering a commercial debt obligation settled: it has become a parked obligation and the specified cost is less than 80% of the principal amount of the obligation. This provision deems that the debtor settled the obligation at that time and paid an amount equal to the specified cost to the owner. In the example you provided, since the specified cost is greater than 80% of the principal amount, subsection 80.01(8) would not apply. If Purchaseco and Targetco were to amalgamate, subsection 80.01(3) would apply to deem a settlement of the debt if all the conditions described therein are met. The debt would be deemed to be settled immediately before the time that is immediately before the amalgamation for an amount equal to an amount that would have been the creditor's "cost amount" (as described in paragraphs (a) and (b) of subsection 80.01(3)) of the indebtedness at that time.
We trust that these comments will be of assistance.
Yours truly,
Steve Tevlin
for Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch
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