Translation disclaimer
This translation was prepared by Tax Interpretations Inc. The CRA did not issue this document in the language in which it now appears, and is not responsible for any errors in its translation that might impact a reader’s understanding of it or the position(s) taken therein. See also the general Disclaimer below.
Principal Issues: [TaxInterpretations translation] What is the measure of capital for the purposes of 20(1)(c): (1) where shares issued as consideration for other shares have, by reason of subsection 85(2.1), a paid-up capital in excess of the stated capital of the transferred shares; or (2) where the legal capital is increased by an amount equal to consolidated safe income?
Position: 1) and 2) Question of fact.
Reasons: 1) and 2) Stated capital is generally the measure where the capital has been used to earn business income as in Trans-Prairie Pipelines Ltd.
2003-005197
XXXXXXXXXX Michelle Desrosiers,
Notary M.Fisc.
May 31, 2004Dear Sir,
Subject: Paragraph 20(1)(c) of the Income Tax Act (the "Act")
This is further to your request received on December 2, 2003, regarding the concept of capital for the purposes of paragraph 20(1)(c) of the Act. Specifically, you wish to know the position of the Canada Revenue Agency (the “Agency") position on the deduction, pursuant to paragraph 20(1)(c), for interest incurred on a loan to repay capital in the following two situations:
Situation 1
Holdco owns all of the shares of Opco, being 100 common shares. The fair market value (FMV) of the Opco shares is $800,000, their adjusted cost base (ACB) is $700,000 and their stated capital is $100,000. Holdco transfers the Opco shares to a new wholly-owned subsidiary, Newco, in exchange solely for common shares of Newco. The election under section 85 of the Act is made to set the agreed-upon amount at $700,000. Pursuant to subsection 85(2.1) of the Act, the paid-up capital of the common shares of Newco is reduced by $100,000 to $700,000. Newco borrows $800,000 and makes a payment of the same amount to Holdco as a return of capital.
Situation 2
Holdco holds all of the shares of Opco. The income earned or realized within the meaning of subsection 55(2) attributable to the Opco shares held by Holdco is $600,000. Opco holds all of the shares of Subco. The income earned or realized attributable to the Opco shares consists of $200,000 of income earned or realized by Opco and $400,000 of income earned or realized by Subco. The stated capital of the Opco shares is increased by $600,000. Opco borrows $600,000 and makes a payment of the same amount to Holdco as a return of capital.
In both of the transactions described, we have assumed that all the corporations involved are taxable Canadian corporations as defined in the Act.
The situation you have indicated in your documents relates to an actual situation concerning you. As explained in Information Circular 70-6R5, it is not the Directorate's practice to comment on proposed transactions involving specific taxpayers otherwise than in the form of an advance tax ruling. We are, however, prepared to provide the following general comments, which you may find useful.
In Bronfman Trust v. Canada, 87 DTC 5059 (SCC), the court stated that "... the text of the Act requires tracing the use of borrowed funds to a specific eligible use” and that "[t]he onus is on the taxpayer to trace the borrowed funds to an identifiable use which triggers the deduction.” In Shell Canada Ltd. v. Canada, 99 DTC 5669 (SCC), the court described the test for determining the use of borrowed money by stating that: "If a direct link can be drawn between the borrowed money and an eligible use... " then the money was used to earn income from a business or property. It also stated: "Interest is deductible only if there is a sufficiently direct link between the borrowed money and the current eligible use... ". The applicable criterion therefore remains the direct use of the borrowed money.
However, in some cases, the courts have stated that indirect use will be accepted, but only as an exception to the direct use test. For example, in Trans-Prairie Pipelines Ltd. v. MNR, 70 DTC 6351 (Exchequer Court) ("Trans-Prairie"), the Court held that interest was deductible on money borrowed by the taxpayer in connection with the redemption of its preferred shares. It concluded that the borrowed money had been returned to the shareholders "as a practical matter of business common sense, … to fill the hole left by redemption …” of the preferred shares. The Supreme Court of Canada in Singleton v. Canada, 2001 DTC 5533, summarized the principle established in Trans-Praire as follows: "In allowing the deduction, the court reasoned that prior to the transaction the taxpayer’s capital consisted in part of the $700,000 subscribed by preferred shareholders" and “as a practical matter of business common sense, [the $700,000 of borrowed money] went to fill the hole left by the redemption of the $700,000 preferred [shares].”
This concept is reproduced in paragraph 23 of IT-533 as follows:
“…[T]he purpose test will be met if the borrowed money replaces capital (contributed capital or accumulated profits) that was being used for purposes that would have qualified for interest deductibility had the capital been borrowed money (eligible purposes). Consistent with the concept of filling the hole, contributed capital generally means the funds provided by the shareholders to commence, or otherwise further, the carrying on of the business. While in most situations the legal or stated capital for corporate law purposes would be the best measurement of contributed capital for this purpose, other measurements may be more appropriate depending on the circumstances. […] The key concept in this context remains that of "filling the hole" of capital withdrawn from the business.”
However, there may be situations where the legal or stated capital of shares is not an appropriate measure of capital as in the cases described above.
Best regards,
Section Manager
For the Director of the Division
Financial Industries Division
Income Tax Rulings Directorate
Policy and Planning Branch
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