2004 Ruling 2003-0050081R3 - interest deductibility

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.

Principal Issues: is interest on Canco loan used to return contributed surplus to its parent deductible in these particular circumstances

Position: yes

Reasons: particular fact situation

XXXXXXXXXX 2003-005008

XXXXXXXXXX 2004

Dear XXXXXXXXXX:

Re: XXXXXXXXXX
Advance Income Tax Ruling

We are writing in response to your letter of XXXXXXXXXX wherein you requested an advance income tax ruling on behalf of the above taxpayer.

To the best of your knowledge and that of the taxpayers involved, the proposed transactions will not impact the ability of the taxpayers involved to pay their existing tax liabilities.

To the best of your knowledge and that of the taxpayers involved, none of the issues contained in this ruling request are:

(i) dealt with in an earlier return of the taxpayers or a related person;

(ii) being considered by a tax services office or taxation centre in connection with a previously filed tax return of the taxpayer or a related person;

(iii) under objection by the taxpayer or a related person;

(iv) subject to a ruling previously issued by the Income Tax Rulings Directorate; or

(v) before the courts or, if a judgment has been issued, the time limit for appeal to a higher court has not expired.

DEFINITIONS

In this letter, the following terms have the meanings specified:

(a) "Act" means the Income Tax Act, R.S.C. 1985 (5th Suppl.) c.1, as amended to the date hereof, and unless otherwise stated, a reference herein to a part, section, subsection, paragraph or subparagraph is a reference to the relevant provision of the Act and the regulations thereunder are referred to as the "Regulations";

(b) "Activity" means the XXXXXXXXXX industry;

(c) "adjusted cost base" has the meaning assigned by section 54;

(d) "arm's length" has the meaning assigned by subsection 251(1);

(e) "Bank Credit Agreement" has the meaning assigned by Paragraph 28;

(f) "Borrowers" has the meaning assigned by Paragraph 28;

(g) "Borrowing" has the meaning assigned by Paragraph 8;

(h) "Canco" means XXXXXXXXXX;

(i) "Canco Business" means two industry segments of the Group Business that are carried on within Canada, namely the XXXXXXXXXX industry and the XXXXXXXXXX industry. Canco's XXXXXXXXXX segment does some manufacturing, XXXXXXXXXX;

(j) "Canco Loan" has the meaning assigned by Paragraph 24;

(k) "Company Act" means the Companies Act of XXXXXXXXXX, as amended;

(l) "Corporate Act" means the Business Corporations Act of XXXXXXXXXX, as amended;

(m) "Canco Predecessor #1" means the former XXXXXXXXXX and predecessor to Canco;

(n) "Canco Predecessor #1 Advance #1" has the meaning assigned by Paragraph 15;

(o) "Canco Predecessor #1 Advance #2" has the meaning assigned by Paragraph 15;

(p) "Canco Predecessor #2" means the former XXXXXXXXXX and predecessor to Canco;

(q) "controlled foreign affiliate" has the meaning assigned by subsection 95(1);

(r) "CRA" means the Canada Revenue Agency;

(s) "Distribution" has the meaning assigned in Paragraph 25;

(t) "foreign affiliate" has the meaning assigned by subsection 95(1);

(u) "Foreign Affiliate #1" means XXXXXXXXXX. Foreign Affiliate #1 is a corporation incorporated in and resident in Foreign country #2;

(v) "Foreign Affiliate #1 Debt" has the meaning assigned by Paragraph 9;

(w) "Foreign Affiliate #2" means XXXXXXXXXX. Foreign Affiliate #2 is a corporation incorporated in and resident in Foreign country #3;

(x) "Foreign Affiliate #2 Debt" has the meaning assigned by Paragraph 10;

(y) "ForeignCo #1" means XXXXXXXXXX . ForeignCo #1 is a corporation incorporated in and resident in Foreign country #1 and is controlled by Foreign GrandparentCo;

(z) "ForeignCo #2" means XXXXXXXXXX;

(aa) "Foreign country #1" means XXXXXXXXXX;

(bb) "Foreign country #2" means XXXXXXXXXX;

(cc) "Foreign country #3" means XXXXXXXXXX;

(dd) "Foreign country #4" means XXXXXXXXXX;

(ee) "Foreign GrandparentCo" means XXXXXXXXXX. Foreign GrandparentCo is a corporation incorporated in and resident in the Foreign country #1. The shares of Foreign GrandparentCo are listed on the XXXXXXXXXX Stock Exchange;

(ff) "Foreign ParentCo" means XXXXXXXXXX. Foreign ParentCo is a corporation incorporated in and resident in the Foreign country #1;

(gg) "Former Foreign Affiliate" means XXXXXXXXXX (formerly XXXXXXXXXX). Former Foreign Affiliate is a corporation incorporated in and resident in Foreign country #4;

(hh) "GAAP" means Canadian Generally Accepted Accounting Principles;

(ii) "Group Business" means the XXXXXXXXXX business, XXXXXXXXXX;

(jj) "paid-up capital" has the meaning assigned by subsection 89(1);

(kk) "Paragraph" means a numbered paragraph in this advance income tax ruling;

(ll) "Proposed Transactions" means the transactions described in Paragraph 24 to Paragraph 27;

(mm) "related person" has the meaning assigned by subsection 251(2);

(nn) "series of transaction or events" means "series of transactions or events" for purposes of the Act as modified by subsection 248(10);

(oo) "specified non-resident shareholder" has the meaning assigned by subsection 18(5);

(pp) "stated capital" has the meaning assigned by the Company Act;

(qq) "taxable Canadian corporation" has the meaning assigned by subsection 89(1);

(rr) "TC" means Taxation Centre;

(ss) "Treaty" means the Canada - XXXXXXXXXX Tax Convention XXXXXXXXXX, as amended to the date hereof; and

(tt) "TSO" means Tax Services Office.

STATEMENT OF FACTS

1. Canco is an unlimited liability company that was formed under the Company Act on XXXXXXXXXX as a result of the amalgamation of Canco Predecessor #1 and Canco Predecessor #2. Canco is a private corporation and a taxable Canadian corporation.

Canco Predecessor #2 was an unlimited liability company that was incorporated under the Company Act on XXXXXXXXXX. Canco Predecessor #2 was a private corporation and a taxable Canadian corporation and was wholly-owned by Foreign ParentCo. Canco Predecessor #2 was formed for the purpose of amalgamating with Canco Predecessor #1 to form Canco as an unlimited liability company.

Canco Predecessor #1 was a corporation that was incorporated under the Corporate Act and that continued under the Company Act on XXXXXXXXXX and that carried on the Group Business in Canada. Canco Predecessor #1 was a private corporation and a taxable Canadian corporation and was wholly-owned by Foreign ParentCo prior to and at the time of being amalgamated with Canco Predecessor #2.

2. Canco's mailing address is: XXXXXXXXXX . Canco's business number is XXXXXXXXXX. Canco files its tax returns at the XXXXXXXXXX TC and is serviced by the XXXXXXXXXX TSO. Canco has a XXXXXXXXXX year-end for tax and accounting purposes.

3. Canco's authorized share capital consists of XXXXXXXXXX common shares without nominal or par value. Canco's issued share capital consists of XXXXXXXXXX Class A common shares. Canco's XXXXXXXXXX Class A common shares have a stated capital of $XXXXXXXXXX and a paid-up capital of $XXXXXXXXXX. All of Canco's XXXXXXXXXX issued and outstanding Class A common shares are owned by Foreign ParentCo, which is a wholly-owned subsidiary of Foreign GrandparentCo. Canco is the only corporation incorporated in and resident in Canada within the Foreign GrandparentCo corporate structure.

4. As of XXXXXXXXXX, Canco's shareholder's equity as reflected in its non-consolidated financial statements was $XXXXXXXXXX. This amount includes share capital of $XXXXXXXXXX, contributed surplus of $XXXXXXXXXX and retained earnings of $XXXXXXXXXX. Canco prepares its financial statements in conformity with GAAP, except that they are prepared on a non-consolidated basis and its investments in subsidiaries are carried at cost.

5. Foreign GrandparentCo and its subsidiaries, on a worldwide basis, carry on the Group Business. Canco carries on the Canco Business. Canco is also a holding corporation for certain controlled foreign affiliates, as described in Paragraphs 6 and 7.

6. Canco owns approximately XXXXXXXXXX% of the shares of the capital stock of Foreign Affiliate #1, which is a controlled foreign affiliate of Canco. Foreign Affiliate #1 carries on business in the XXXXXXXXXX industries within Foreign country #2. Two corporations that are resident in Foreign country #1 and that are controlled by Foreign GrandparentCo own the remaining issued and outstanding shares of Foreign Affiliate #1. Foreign Affiliate #1's issued and outstanding share capital consists of XXXXXXXXXX common shares. Canco owns XXXXXXXXXX of the common shares of Foreign Affiliate #1.

Recently, as a result of a reorganization, Foreign Affiliate #1 commenced carrying on business in the Activity industry within Foreign country #2.

7. Foreign Affiliate #2 carries on business in the XXXXXXXXXX and Activity industries within Foreign country #3. Foreign Affiliate #2's issued and outstanding share capital consists of XXXXXXXXXX Class I common shares, which represent the fixed minimum capital, XXXXXXXXXX Class II common shares and XXXXXXXXXX Class III preferred shares. Canco owns approximately XXXXXXXXXX % of the shares of the capital stock of Foreign Affiliate #2, which is a controlled foreign affiliate of Canco. Former Foreign Affiliate owns the remaining issued and outstanding shares of Foreign Affiliate #2. Canco owns XXXXXXXXXX of the Class I shares and all XXXXXXXXXX of the Class II common shares. Former Foreign Affiliate owns all XXXXXXXXXX of the Class III preferred shares. The Class III preference shares were issued in XXXXXXXXXX.

The Borrowing: Debts incurred by Canco in XXXXXXXXXX

8. On XXXXXXXXXX, Canco Predecessor #1 borrowed $XXXXXXXXXX (the "Borrowing") XXXXXXXXXX pursuant to the terms of a XXXXXXXXXX agreement. The funds borrowed by Canco Predecessor #1 were used to acquire all of the issued and outstanding shares in Foreign Affiliate #1, Foreign Affiliate #2 and approximately XXXXXXXXXX% of the issued and outstanding shares of Former Foreign Affiliate from Foreign GrandparentCo or companies controlled by Foreign GrandparentCo.

XXXXXXXXXX

Acquisition of Foreign Affiliate #1

9. Canco Predecessor #1 used $XXXXXXXXXX of the Borrowing (the "Foreign Affiliate #1 Debt"), to acquire shares in Foreign Affiliate #1. The acquisition by Canco Predecessor #1 of the shares in Foreign Affiliate #1 was financed entirely with the Foreign Affiliate #1 Debt.

Acquisition of Foreign Affiliate #2

10. Canco Predecessor #1 used $XXXXXXXXXX of the Borrowing (the "Foreign Affiliate #2 Debt"), to acquire shares in Foreign Affiliate #2. The acquisition by Canco Predecessor #2 of the shares in Foreign Affiliate #2 was financed entirely with the Foreign Affiliate #2 Debt.

Acquisition of Former Foreign Affiliate

11. Canco Predecessor #1 used $XXXXXXXXXX of the Borrowing (the "Former Foreign Affiliate Debt"), to acquire shares in Former Foreign Affiliate. In addition to financing the acquisition of its shares in Former Foreign Affiliate with the Former Foreign Affiliate Debt, Canco Predecessor #1 financed this acquisition with $XXXXXXXXXX in available cash on hand.

12. Canco Predecessor #1 acquired XXXXXXXXXX common shares of Former Foreign Affiliate, representing approximately XXXXXXXXXX% of the total issued and outstanding common shares of Former Foreign Affiliate of XXXXXXXXXX, for a cost of $XXXXXXXXXX. Former Foreign Affiliate held a number of wholly and partly owned European subsidiaries with active business operations in Europe.

Disposition of Shares of Former Foreign Affiliate

13. On XXXXXXXXXX, Canco Predecessor #1 disposed of, at fair market value, XXXXXXXXXX common shares of Former Foreign Affiliate to ForeignCo #1 for proceeds of $XXXXXXXXXX. Canco Predecessor #1 received a third party appraisal of the fair market value of the total issued and outstanding common shares of Former Foreign Affiliate (i.e., XXXXXXXXXX common shares), as of XXXXXXXXXX.

14. On XXXXXXXXXX, Canco Predecessor #1 disposed of, at fair market value, its remaining XXXXXXXXXX common shares of Former Foreign Affiliate to Foreign Co #1 for proceeds of $XXXXXXXXXX . Canco Predecessor #1 received an updated appraisal of the fair market value of the total issued and outstanding common shares of Former Foreign Affiliate (i.e., XXXXXXXXXX common shares), as of XXXXXXXXXX, from the same third party that provided the valuation as of XXXXXXXXXX.

15. Canco Predecessor #1 used the proceeds from the dispositions of the Former Foreign Affiliate shares to repay the Former Foreign Affiliate Debt and the excess proceeds were used to repay the Foreign Affiliate #1 Debt and the Foreign Affiliate #2 Debt (i.e., the debt that was used to acquire Foreign Affiliate #1 and Foreign Affiliate #2), and approximately $XXXXXXXXXX was used for the general business operations being carried on by Canco Predecessor #1.

Specifically, on XXXXXXXXXX, ForeignCo #2, a corporation resident in Foreign country #1 and controlled by Foreign GrandparentCo, advanced $XXXXXXXXXX to Canco Predecessor #1 (the "Canco Predecessor #1 Advance #1"). ForeignCo #2 then assigned the Canco Predecessor #1 Advance #1 to ForeignCo #1 through a capital contribution in kind. ForeignCo #1 paid for the Former Foreign Affiliate shares, acquired on XXXXXXXXXX, by discharging and cancelling, as assignee, $XXXXXXXXXX of the Canco Predecessor #1 Advance 1.

On XXXXXXXXXX, ForeignCo #2 advanced $XXXXXXXXXX to Canco Predecessor #1 (the "Canco Predecessor #1 Advance #2"). ForeignCo #2 paid for the Former Foreign Affiliate shares, acquired on XXXXXXXXXX, by crediting Canco Predecessor #1 with the payment of $XXXXXXXXXX on account of the Canco Predecessor #1 Advance #2.

Canco Predecessor #1 used the cash proceeds provided by the Canco Predecessor #1 Advance #1 and the Canco Predecessor #1 Advance #2 to repay the Former Foreign Affiliate Debt, the Foreign Affiliate #1 Debt and the Foreign Affiliate #2 Debt, and for general corporate purposes.

16. For accounting purposes, Canco Predecessor #1's investment in Former Foreign Affiliate was recorded on a cost basis throughout the period during which Canco Predecessor #1 held the Former Foreign Affiliate shares and the accounting gains on the dispositions of the Former Foreign Affiliate shares were recorded as contributed surplus in conformity with GAAP.

17. Between the time of acquisition and the times of the dispositions by Canco Predecessor #1 of the Former Foreign Affiliate shares, there were no adjustments required to the adjusted cost base of the Former Foreign Affiliate shares owned by Canco Predecessor #1. Therefore, Canco Predecessor #1 had an adjusted cost base in the Former Foreign Affiliate shares of $XXXXXXXXXX.

18. With respect to the XXXXXXXXXX disposition of the Former Foreign Affiliate shares by Canco Predecessor #1, Canco Predecessor #1 reduced its capital gain on the disposition by making an election under subsection 93(1) and by claiming a deduction under subsection 113(1). For accounting purposes, the gain on the disposition of the Former Foreign Affiliate shares of $XXXXXXXXXX was recorded as contributed surplus.

19. With respect to the XXXXXXXXXX disposition of the Former Foreign Affiliate shares by Canco Predecessor #1, Canco Predecessor #1 reduced its capital gain on the disposition by making an election under subsection 93(1) and by claiming a deduction under subsection 113(1). For accounting purposes, the gain on disposition of $XXXXXXXXXX was recorded as contributed surplus.

20. In total, with respect to the dispositions of the Former Foreign Affiliate shares by Canco Predecessor #1, Canco Predecessor #1 received proceeds of disposition of $XXXXXXXXXX. Canco Predecessor #1 reduced its capital gain on the dispositions by making elections under subsection 93(1) and by claiming deductions under subsection 113(1). For accounting purposes, the total gain on the dispositions of the Former Foreign Affiliate shares of $XXXXXXXXXX was recorded as contributed surplus. Therefore, the total contributed surplus of $XXXXXXXXXX, recorded in Canco Predecessor #1's non-consolidated financial statements as of XXXXXXXXXX relates to the gain on the dispositions of the Former Foreign Affiliate shares.

21. Canco (as a consequence of the amalgamation described in Paragraph 1) continues to own shares in Foreign Affiliate #1 and Foreign Affiliate #2 that were acquired by Canco Predecessor #1 in XXXXXXXXXX. However, both Foreign Affiliate #1 and Foreign Affiliate #2 have been through a number of reorganizations since Canco Predecessor #1 acquired the shares of Foreign Affiliate #1 and Foreign Affiliate #2 as described in Paragraphs 9 and 10. As a result, Canco currently owns less than all of the issued and outstanding shares of Foreign Affiliate #1 and Foreign Affiliate #2 as described in Paragraphs 6 and 7. The decrease in the percentage of the Foreign Affiliate #1 and the Foreign Affiliate #2 shares owned by Canco is a result of these reorganizations and not as a result of Canco disposing of any of its investment in Foreign Affiliate #1 or Foreign Affiliate #2.

22. Canco and its predecessor, Canco Predecessor #1 have received dividends from Foreign Affiliate #1 of approximately $XXXXXXXXXX since the shares of Foreign Affiliate #1 were acquired and have received dividends from Foreign Affiliate #2 of approximately $XXXXXXXXXX since the shares of Canco Predecessor #2 were acquired. Foreign Affiliate #1 and Foreign Affiliate #2 have no dividend policy but have paid dividends as circumstances permit.

23. To the best of your knowledge and that of Canco, the Proposed Transactions will not impact the ability of Canco to pay its existing tax liabilities.

PROPOSED TRANSACTIONS

24. Canco will borrow an amount not exceeding the amount of its contributed surplus from Foreign Grandparent or from a company controlled by Foreign Grandparent (the "Canco Loan"). The Canco Loan will bear interest at Canadian LIBOR plus XXXXXXXXXX percent (which currently is about XXXXXXXXXX%), or other such rate that is determined to be comparable to prevailing commercial rates at the time the Canco Loan is granted. The interest rate will be determined at the time the Canco Loan is granted and the interest will be payable annually. The Canco Loan will be denominated in Canadian currency and will be repayable on demand.

25. Canco will use the proceeds from the Canco Loan to distribute an amount of its contributed surplus (equal to the principal amount of the Canco Loan) to Foreign Parent (the "Distribution"). Canco will withhold and remit tax on the Distribution as required under Part XIII, subject to the application of Article X of the Treaty.

26. Interest on the Canco Loan will be payable annually. Canco will withhold and remit tax on the interest payments as required under Part XIII, subject to the application of Article XI of the Treaty.

27. Pursuant to the Company Act, the stated capital of Canco's issued and outstanding XXXXXXXXXX Class A common shares will be increased by converting all or a portion of Canco's remaining contributed surplus, if any, into stated capital. Canco will withhold and remit tax on the dividend deemed to arise as a consequence of this transaction as required under Part XIII, subject to the application of Article X of the Treaty.

PURPOSE OF THE PROPOSED TRANSACTIONS

28. The purpose of the Proposed Transactions is to allow Foreign ParentCo to refinance its investment in Canco by replacing some of its capital investment with debt within the limits prescribed under the thin capitalization rules. XXXXXXXXXX.

RULINGS

Provided that the preceding statements constitute a complete and accurate disclosure of all of the relevant warranties on page 1 of this advance income tax ruling, as well as all of the relevant facts, proposed transactions and purpose of the proposed transactions, and provided that the proposed transactions are completed in the manner described above, our rulings are as set forth below:

A. Provided that Canco has a legal obligation to pay interest on the Canco Loan as described in Paragraph 24 and that Canco uses the proceeds from the Canco Loan to make the Distribution described in Paragraph 25, Canco will be entitled, pursuant to paragraph 20(1)(c) to deduct the lesser of (i) the interest paid or payable (depending on the method regularly followed by Canco in computing its income for purposes of the Act) in respect of the year on the Canco Loan or (ii) a reasonable amount in respect thereof, subject to the application of subsection 18(5).

B. As a result of the Proposed Transactions, in and by themselves, subsection 245(2) will not apply to redetermine the tax consequences confirmed in the ruling given.

CAVEAT

The above rulings are given subject to the general limitations and qualifications set out in Information Circular 70-6R5 (the "Circular") issued by the CRA on May 17, 2002, and are binding provided the Proposed Transactions described in Paragraphs 24 to 27 are completed on or before XXXXXXXXXX.

These rulings are based on the Act in its present form and do not take into account the effect of any proposed amendments to the Act.

Nothing in this letter should be construed as implying that the CRA has agreed to or accepted:

(i) the cost or fair market value of any property referred to in this letter;

(ii) the accuracy of any amounts referred to in this letter;

(iii) the GST implications of any of the proposed transactions;

(iv) any other tax consequences of the proposed transactions or of related transactions or events that are not described herein.

Yours truly,

XXXXXXXXXX
for Director
Financial Industries Division
Income Tax Rulings Directorate