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:
Interest deduction on money borrowed to pay dividends
Position TAKEN:
Interest may be deductible on amount borrowed up to retained earnings
Reasons FOR POSITION TAKEN:
See Trans-Prairie and Chase Manhattan
XXXXXXXXXX 2002-017694
G. Moore
March 25, 2003
Dear XXXXXXXXXX:
Re: Interest deduction on funds borrowed to pay dividends
This is in reply to your letter of November 27, 2002, in which you ask for our comments regarding interest deductibility under paragraph 20(1)(c) of the Income Tax Act (the "Act").
In the hypothetical situation, A Co. is a Canadian controlled private corporation. Holdco owns all the shares of A Co. and A Co. pays dividends annually to Holdco. A portion of the dividends received by Holdco have been loaned to A Co. as a non-interest bearing loan. A Co. uses the loan is to pay dividends to Holdco. The dividends paid have exceeded A Co.'s retained earnings and as a result, A Co has a deficit. Holdco wants to convert a portion of the non-interest bearing loan into an interest-bearing loan. Provided the remaining non-interest bearing loan is equal to or greater than the deficit, would the interest paid by A Co. on the interest-bearing loan be deductible? In your view, the interest on the newly created interest-bearing loan would be deductible since the debt can be related to dividend payments that did not exceed A Co.'s retained earnings.
The particular situation outlined in your letter appears to relate to a factual one, involving a specific taxpayer. As explained in Information Circular 70-6R5 dated May 17, 2002, 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.
Paragraph 20(1)(c) of the Act permits the deduction of an amount paid in the year or payable in respect of the year, pursuant to a legal obligation to pay interest on borrowed money used for the purpose of earning income from a business or property. The Supreme Court has outlined that direct use is the primary test to determine interest deductibility and that indirect uses will not be acceptable, other than in exceptional circumstances. Trans-Prairie Pipelines Ltd. is the leading case with regard to exceptional circumstances and remains valid today. This case addressed the exceptional circumstances of borrowing to redeem shares. The concept of using borrowing money to "fill the hole" of capital withdrawn from the corporation's business is a key element of this concept.
The amount of capital used for an eligible purpose of earning income prior to the replacement of that capital with borrowed money must be determined. Capital includes the contributed capital and accumulated profits of a corporation. Contributed capital is considered to be the funds provided by the owners of a corporation to commence or to further the carrying on of the corporate business. In most corporate situations, the legal or stated capital for corporate law purposes would be the best measurement of capital for this purpose, although other measurements may be more appropriate depending on the circumstances.
Borrowing to pay dividends is an ineligible direct use, but interest deductibility in such situations may be provided under the exceptional circumstances category, consistent with the concept of borrowing to replace capital to "fill the hole" described above. We generally accept this category of exceptional circumstances and generally accept accumulated profits as the appropriate measurement of the hole that may be filled with the borrowed money used to pay a dividend.
A corporation may borrow to pay dividends to the extent of its accumulated profits or retained earnings. Generally, accumulated profits means retained earnings computed on an unconsolidated basis with investments accounted for on a cost basis. However, profits or gains resulting from the disposition of property to persons with whom the taxpayer does not deal at arm's length will generally be excluded. In Chase Manhattan Bank of Canada v. The Queen, 2000 DTC 6018, the Court upheld the position that interest on borrowed money used to pay dividends, to the extent the loan exceeds retained earnings, is not deductible.
However, with respect to the fact that the dividends paid by A Co. to Holdco have exceeded A Co.'s retained earnings, we cannot comment on whether the interest on the interest-bearing loan would be deductible to the extent of A Co.'s retained earnings as we do not have sufficient details. For example, you have not indicated how a portion of the non-interest bearing loan would be converted to an interest-bearing loan or how the interest-bearing loan is linked to a portion of the dividends paid that do not exceed A Co.'s retained earnings. Whether the interest-bearing loan could be traced or linked to the original payment of dividends, up to the amount of retained earnings, would be a question of fact.
Lastly, A Co. has paid dividends that exceed retained earnings and therefore, A Co. has a deficit. We note that section 42 of the Canada Business Corporations Act ("CBCA") provides that a corporation shall not declare or pay any dividend if there are reasonable grounds for believing that (a) the corporation is, or would after the payment be, unable to pay its liabilities as they become due; or (b) the realizable value of the corporation's assets would thereby be less than the aggregate of its liabilities and stated capital of all classes. There may be similar provincial legislation which may be applicable if a corporation was incorporated under provincial legislation rather than the CBCA.
On February 18, 2003, as part of the presentation of the Federal budget, the Department of Finance published the following statement concerning the deductibility of interest:
"Recent court decisions have raised uncertainties as to how taxpayers are to treat expenses, in particular interest, in computing income from a business or property for purposes of the Income Tax Act. Most notably, these decisions could lead to inappropriate tax results where a taxpayer derives a tax loss by deducting interest expenses, even if under any objective standard there is no reasonable expectation that the taxpayer would earn any income (as opposed to capital gains), or where the presence or the prospect of revenue (as opposed to income net of expenses) is enough to conclude that an expenditure was incurred "for the purpose of earning income".
Neither of these results is consistent with appropriate tax policy, nor would they have been generally expected under prior law and practice. Therefore legislative amendments to the Income Tax Act will be considered in order to provide continuity in this important area of the law. Before finalizing any proposals, however, the Department of Finance will release them for public consultation, with a general goal of ensuring that they restore continuity with the expected consequences before these recent court decisions."
We trust that our comments will be of assistance to you.
S. Tevlin
for Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch
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