2005 Ruling 2005-0152251R3 - Interest Expense - Substituted Property

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: Does interest remain deductible when property that was acquired in the course of borrowing money is substituted for other income earning property?

Position: YES

Reasons: Substituted Property - paragraph 27 of IT 533

XXXXXXXXXX 								2005-015225

XXXXXXXXXX, 2005

Dear XXXXXXXXXX,

Re: Advance Income Tax Ruling
XXXXXXXXXX. ("A Co")

We are writing in response to your letter of XXXXXXXXXX, wherein you requested an advance income tax ruling in respect of the above named corporation. We acknowledge the additional information received on XXXXXXXXXX

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 tax return of A Co or a related person;

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

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

(iv) before the courts, or if a judgment has been issued, the time limit for appeal to a higher court has expired; or

(v) the subject of a ruling previously issued by the Income Tax Rulings and Interpretation Directorate of the Canada Revenue Agency ("CRA").

To the best of your knowledge and that of the responsible officers of A Co, the Proposed Transactions will not have any impact on outstanding existing tax liabilities, if any, of A Co.

DEFINITIONS

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

(a) "A Co" means XXXXXXXXXX., as described in Paragraph 3;

(b) "Acquisition Price" means the consideration received for the Transferred Shares as described in Paragraph 13;

(c) "Act" means the Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.), as amended to the date hereof;

(d) "active business" has the meaning assigned by subsection 95(1) of the Act;

(e) "arm's length" has the meaning assigned by section 251 of the Act;

(f) "B Co" means XXXXXXXXXX as described in Paragraph 9;

(g) "B Co Shares" means shares of B Co as described in Paragraph 12;

(h) "C Co Shares" means shares of XXXXXXXXXX as described in Paragraph 12;

(i) "CBCA" means the Canada Business Corporations Act;

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

(k) "C Co" means XXXXXXXXXX as described in Paragraph 7;

(l) "D Co" means XXXXXXXXXX as described in Paragraph 10;

(m) "D Co Shares" means the shares of D Co as described in Paragraph 12;

(n) "E Co" means XXXXXXXXXX as described in Paragraph 9;

(o) "E Co Leasing" means a subsidiary of a XXXXXXXXXX holding company directly held by E Co as described in Paragraph 9;

(p) "fair market value" means the amount at which property would exchange hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts;

(q) "H Co " means XXXXXXXXXX as described in Paragraph 10;

(r) "I Co" means XXXXXXXXXX as described in Paragraph 9;

(s) "IF Co" means XXXXXXXXXX. as described in Paragraph 8;

(t) "LP" means XXXXXXXXXX and Company LP as described in Paragraph 8;

(u) "New LP" means a new limited partnership as described in Paragraph 20;

(v) "Note" means a promissory note issued by A Co to W Co as described in Paragraph 15;

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

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

(y) "Preference Shares" means voting preference shares of A Co as described in Paragraph 6;

(z) "principal amount" has the meaning assigned by subsection 248(1) of the Act;

(aa) "Proposed Transactions" means the proposed transactions described in Paragraphs 22 to 29;

(bb) "Regulations" means Income Tax Regulations, Consolidated Regulations of Canada, Chapter 945 as amended to the date hereof;

(cc) "Reinvestment Agreement" means an agreement between T Co, A Co and W Co as described in Paragraph 18;

(dd) "related persons" has the meaning assigned by subsection 251(2) of the Act;

(ee) "Share Transfer Agreement" means a share transfer agreement entered into by A Co and W Co as described in Paragraph 12;

(ff) "taxable Canadian corporation" has the meaning assigned by subsection 89(1) of the Act;

(gg) "T Co" means XXXXXXXXXX as described in Paragraph 11;

(hh) "third parties" means persons who act at arm's length with the X Group;

(ii) "Transferred Shares" has the meaning described in Paragraph 12;

(jj) "Treaty" means the Canada-United States Income Tax Convention;

(kk) "W Co" means XXXXXXXXXX as described in Paragraph 2;

(ll) "X Co" means XXXXXXXXXX as described in Paragraph 1;

(mm) "X Group" means X Co and entities related to X Co;

(nn) "Z Co" means XXXXXXXXXX, as described in Paragraph 6.

FACTS

1. X Co is a corporation that was incorporated in the United States and that is a resident thereof for the purposes of the Act and the Treaty. X Co is the parent corporation of the X Group. The X Group carries on business throughout the world. The X Group's business involves the XXXXXXXXXX.

2. W Co is a corporation that was incorporated in the United States and that is a resident thereof for the purposes of the Act and the Treaty. W Co is a wholly-owned subsidiary of X Co.

3. A Co is a corporation that was originally incorporated in XXXXXXXXXX under the laws of Canada and that is governed by the CBCA. A Co is a taxable Canadian corporation for the purposes of the Act and is a resident of Canada for the purposes of the Act and the Treaty. A Co is the X Group's principal Canadian operating company.

4. A Co is engaged directly and through subsidiaries in the XXXXXXXXXX

5. From time to time, A Co has acquired businesses from third parties by way of asset or share purchases. The businesses have subsequently been carried on directly by A Co or by A Co subsidiaries. In addition, A Co has made equity investments in X Group members, whether by purchasing shares from X Group members, or by subscribing for equity of X Group members.

6. A Co's articles of incorporation authorize an unlimited number of common and preference shares. A Co has XXXXXXXXXX issued and outstanding common shares, all of which are held by W Co. In addition, A Co has XXXXXXXXXX issued and outstanding Preference Shares. All of the issued and outstanding Preference Shares are held by Z Co, a sister corporation to A Co, all of the common shares of which are indirectly held by W Co.

7. C Co is an unlimited liability company incorporated under and governed by the XXXXXXXXXX. C Co is a taxable Canadian corporation for the purposes of the Act and is a resident of Canada for the purposes of the Act and the Treaty. All of C Co's issued and outstanding shares were acquired by A Co on XXXXXXXXXX from W Co as described in Paragraph 12. The paid-up capital of the C Co Shares, for purposes of the Act, is $XXXXXXXXXX, created on the periodic subscription for common shares by W Co.

8. C Co's business is providing financial services to the A Co group, including the raising of funds from arm's-length third party lenders, the lending of funds to members of the A Co group and the making of certain investments. The business is carried on predominantly through a limited partnership, LP, of which C Co is the majority interest (approximately XXXXXXXXXX%) limited partner. IF Co, a wholly owned subsidiary of A Co, is the general partner (with an approximately XXXXXXXXXX% interest). LP generates income through loans to A Co (currently approximately $XXXXXXXXXX) and investing surplus cash, and, to a minor degree, from other investments.

9. B Co is a corporation that was incorporated under the laws of XXXXXXXXXX. B Co is not a resident of, nor does it carry on business in Canada, for the purposes of the Act. All of B Co's issued and outstanding shares were acquired by A Co on XXXXXXXXXX from W Co as described in Paragraph 12. B Co's principal asset is all of the issued and outstanding shares of the X Group's principal XXXXXXXXXX operating company, E Co. B Co also holds cash and has an interest-bearing deposit with I Co. I Co was incorporated under the laws of XXXXXXXXXX and is not a resident of, nor does it carry on business in Canada, for the purposes of the Act. I Co carries on business in XXXXXXXXXX as an international treasury centre for the X Group. E Co is a resident of XXXXXXXXXX for purposes of the Canada-XXXXXXXXXX Income Tax Convention. E Co carries on in XXXXXXXXXX the business of the XXXXXXXXXX. E Co also owns all of the shares of a XXXXXXXXXX holding company that owns all of the shares of E Co Leasing, a company that carries on the business of leasing XXXXXXXXXX.

10. D Co is a corporation that was incorporated under the laws of XXXXXXXXXX. D Co is a resident of XXXXXXXXXX for the purposes of the Act and the Canada-XXXXXXXXXX Income Tax Convention. D Co does not carry on business in Canada. D Co is the X Group's principal XXXXXXXXXX operating company. D Co carries on in XXXXXXXXXX the business of XXXXXXXXXX. All of D Co's issued and outstanding shares were formerly held by W Co. In XXXXXXXXXX , W Co contributed XXXXXXXXXX% of D Co's issued and outstanding shares to H Co, a limited liability corporation incorporated under the laws of the United States. The transfer of XXXXXXXXXX% of the shares of XXXXXXXXXX was necessary to comply with recent changes to XXXXXXXXXX law, XXXXXXXXXX. A Co acquired XXXXXXXXXX% of the D Co shares from W Co on XXXXXXXXXX , as described in Paragraph 12.

11. T Co is a corporation that was incorporated in the United States and that is a resident thereof for the purposes of the Act and the Treaty. T Co is a wholly-owned subsidiary of W Co.

12. On XXXXXXXXXX, A Co and W Co entered into a share transfer agreement (the "Share Transfer Agreement") pursuant to which A Co agreed to acquire from W Co, and W Co agreed to transfer to A Co, XXXXXXXXXX% of the shares of C Co (the "C Co Shares"), XXXXXXXXXX % of the shares of B Co (the "B Co Shares"), and XXXXXXXXXX% of the shares of D Co (the "D Co Shares") (collectively, the "Transferred Shares"). One of the objectives of the transactions contemplated in the Share Transfer Agreement was the consolidation, under A Co, of the non-U.S. "Americas" corporations (i.e., Canada and XXXXXXXXX).

13. The Share Transfer Agreement provided for the transfer of the Transferred Shares for consideration equal to the fair market value of the Transferred Shares (the "Acquisition Price"). The total fair market value of the Transferred Shares, as determined by A Co and W Co (and supported by third party valuations), was $XXXXXXXXXX, allocated among the Transferred Shares as follows:

(a) as to the C Co Shares, $XXXXXXXXXX;

(b) as to the B Co Shares, $XXXXXXXXXX; and as to the D Co Shares, $XXXXXXXXXX.

14. The consideration provided for the Transferred Shares was as follows:

(a) as to the C Co Shares (i) the issuance and delivery of XXXXXXXXXX common shares of A Co (with a fair market value of $XXXXXXXXXX); and (ii) the issuance of a debt obligation with a principal amount of $XXXXXXXXXX;

(b) as to the B Co Shares (i) the issuance and delivery of XXXXXXXXXX common shares of A Co (with a fair market value of $XXXXXXXXXX); and (ii) the issuance of a debt obligation with a principal amount of $XXXXXXXXXX; and

(c) as to the D Co Shares (i) the issuance and delivery of XXXXXXXXXX common shares of A Co (with a fair market value of $XXXXXXXXXX) and (ii) the issuance of a debt obligation with a principal amount of $XXXXXXXXXX.

15. A Co satisfied the Acquisition Price by

(a) issuing to W Co a secured promissory note with a principal amount of $XXXXXXXXXX (the "Note"); and

(c) issuing to W Co XXXXXXXXXX additional common shares of A Co with a fair market value of $XXXXXXXXXX .

16. The terms of the Note between A Co and W Co are set out therein. The Note is dated the same day as the Share Transfer Agreement, XXXXXXXXXX. The relevant terms of the Note are as follows:

(a) absent an event of default as defined in the Note, the Note has a term of XXXXXXXXXX years;

(b) upon the occurrence of one of the following events of default, the outstanding unpaid principal balance of the Note and all accrued interest will become immediately due and payable:

i. failure by A Co to pay interest when due, if such failure continues for XXXXXXXXXX business days; a breach by A Co of, or a failure by A Co to perform, any material covenant under the Note, where such breach or failure is not cured within XXXXXXXXXX business days of the date on which A Co receives written notice from W Co that A Co must cure such breach or failure;

ii.a material breach by A Co of any of its representations in the Note, or any such representation was materially inaccurate when made and such inaccuracy is not cured within XXXXXXXXXX business days of the date on which A Co receives written notice from W Co that A Co must cure such inaccuracy;

iii.the filing by A Co of a plan for voluntary bankruptcy, or the passing of a resolution to terminate A Co's existence; or

iv.the initiation by another creditor or shareholder of A Co of an involuntary bankruptcy petition for A Co;

(c) the Note bears interest, calculated and payable annually in arrears, at a rate of XXXXXXXXXX%; which is an arm's-length rate for a borrowing by A Co of a like principal amount on similar terms to those set out in the Note;

(d) interest is payable annually by A Co in cash; XXXXXXXXXX% of the interest due is to be paid by A Co directly to the CRA in satisfaction of the Canadian non-resident withholding tax due on the interest payments, and to the extent that the rate of withholding tax (currently 10% under the relevant provision of the Treaty) changes, the portion of interest payable directly to the CRA will be adjusted accordingly;

(e) W Co may, at its option, pay to the CRA on behalf of A Co the withholding tax liability that arises as a result of the payment of interest by A Co, in which case A Co must issue to W Co common shares of A Co having a fair market value equal to the amount of the withholding tax paid by W Co;

(f) A Co has agreed that W Co may appoint a third party to act as a transfer agent to receive the interest payments owing by A Co to W Co under the Note, and if a transfer agent is appointed, A Co is obliged to make the interest payments directly to the transfer agent; under an agreement entered into on the same date as the Share Transfer Agreement and the Note (described in Paragraphs 12 and 15 respectively), W Co appointed T Co as transfer agent for the purposes of the Note;

17. Interest payable by A Co on the Note is being deducted pursuant to subparagraph 20(1)(c)(ii) of the Act. In particular, as relevant to the Proposed Transactions described herein, interest payable on that portion of the Note issued as partial consideration for the B Co shares is being deducted pursuant to subparagraph 20(1)(c)

(ii) for the following reasons:

(a) the interest paid is pursuant to a legal obligation to pay interest as evidenced by the Note,

(b) the interest paid relates to an amount payable for property acquired for the purpose of gaining or producing income from the property; the property acquired being the B Co Shares and the purpose of acquiring the B Co Shares being to gain or produce dividend income from the B Co Shares, and

(c) the interest rate payable by A Co on the Note is an arm's length rate that is reasonable, under the relevant circumstances, for the purposes of the Act.

18. As noted in Paragraph 16(f), on the same date that the Share Transfer Agreement and the Note were entered into, T Co was appointed as W Co's transfer agent for the purposes of the Note. This appointment was made in a transfer agent and reinvestment agreement (the "Reinvestment Agreement") among A Co, T Co, and W Co. The Reinvestment Agreement provides, in part, for the following terms:

(a) T Co was appointed as transfer agent and will act on W Co's behalf to receive all interest payments payable by A Co to W Co under the Note;

(b) W Co irrevocably undertakes to subscribe and irrevocably instructs T Co to subscribe on behalf of W Co, on each interest payment date, for common shares of A Co having an aggregate fair market value equal to the cash amount of interest paid to W Co by A Co (or to T Co on behalf of W Co) in accordance with the Note (net of any withholding tax remitted to the CRA on behalf of W Co);

(c) the full amount of the cash received by W Co (or by T Co on behalf of W Co) is to be used to subscribe for common shares at a price per common share equal to the fair market value of such share, except that no fractional common shares of A Co will be issued (if a fractional common share would have otherwise been issued, the cash representing such fraction is paid to A Co by W Co as additional consideration for the common shares); and

(d) a price adjustment clause is included to operate if the fair market value of A Co common shares issued pursuant to the Reinvestment Agreement is subsequently determined (either by a tribunal or court of competent jurisdiction or by settlement agreement with the CRA) to be different from the fair market value determined by the parties.

19. It is expected that each of C Co, B Co, and D Co will pay dividends to A Co from time to time. There are no non-Canadian laws, or corporate policies or other impediments in respect of any of C Co, B Co, E Co or D Co currently in place or anticipated that would preclude the payment of such dividends.

20. A Co, as limited partner, and IF Co, as general partner, formed a limited partnership in XXXXXXXXXX, New LP, under " XXXXXXXXXX " on XXXXXXXXXX.

21. B Co received dividends from E Co on XXXXXXXXXX of US$XXXXXXXXXX. E Co generated the cash to pay the dividends from its business operations. B Co loaned the funds on a short-term basis to I Co.

PROPOSED TRANSACTIONS

22. A Co and IF Co will enter into a share transfer agreement under which A Co will transfer XXXXXXXXXX% of the B Co Shares to IF Co for consideration equal to the fair market value of XXXXXXXXXX% of the B Co Shares. The consideration provided by IF Co will be common shares of IF Co with a fair market value equal to the fair market value of XXXXXXXXXX% of the B Co Shares. A Co and IF Co will jointly elect pursuant to section 85 of the Act, in prescribed form within the time referred to in subsection 85(6) of the Act for the transfer to occur at the adjusted cost base to A Co of the B Co Shares

23. IF Co will contribute the above XXXXXXXXXX% of B Co Shares to New LP for a XXXXXXXXXX% partnership interest.

24. A Co will contribute the remaining XXXXXXXXXX% of the B Co Shares to New LP for a XXXXXXXXXX% partnership interest. A Co, IF Co and New LP will jointly elect pursuant to subsection 97(2) of the Act, in prescribed form within the time referred to in subsection 96(4) of the Act, for the transfer of the B Co Shares to occur at the adjusted cost base to A Co and IF Co, respectively of the B Co Shares.

25. I Co will remit approximately US$XXXXXXXXXX to B Co as payment of interest and principal on amounts previously loaned to I Co, (including the US$XXXXXXXXXX described in Paragraph 21).

26. B Co will pay a dividend of approximately US$XXXXXXXXXX to New LP.

27. New LP will make an interest-bearing loan of approximately US$XXXXXXXXXX to A Co. The loan will be denominated in Canadian currency and will include arm's length terms and conditions, including a market rate of interest.

28. A Co will accumulate cash generated from operations and possibly borrow an amount from third party lenders. These funds will be added to the amount described in Paragraph 27 to fund the distribution described in Paragraph 29.

29. A Co will distribute approximately US$XXXXXXXXXX to W Co as a return of capital.

OTHER

Neither A Co nor IF Co intend on selling their units in the New LP to the public.

PURPOSE OF PROPOSED TRANSACTIONS

A Co plans to make a distribution to its shareholder, W Co, in XXXXXXXXXX to enable W Co to benefit under special U.S. tax legislation that is in effect for 2005 only. The form of the distribution will be a return of capital for Canadian income tax purposes. The distribution by A Co to W Co will be treated as a dividend for U.S. federal income tax purposes.

The transfer of the B Co shares by A Co to New LP permits the transactions to be completed without incurring a hedging cost. New LP will have a Canadian dollar functional currency for accounting purposes. B Co will pay a US dollar denominated dividend to New LP. New LP will immediately lend the U.S. currency to A Co by way of an equivalent Canadian dollar denominated loan. A Co will immediately upon receipt of the borrowed funds make a return of capital to W Co. As a result of these transactions there should be no necessity to enter into any transactions to hedge against future fluctuations in the value of the U.S. dollar relative to the Canadian dollar.

RULING GIVEN

Provided the preceding statements constitute a complete and accurate disclosure of all the relevant facts, Proposed Transactions and Purpose of the Proposed Transactions, and that the Proposed Transactions are completed in the manner described above, our rulings are set forth below:

Provided that the interest paid or payable by A Co on the Note to W Co as described in paragraphs 12 to 18 above is deductible under subparagraph 20(1)(c)(ii) of the Act, the Proposed Transactions as described in paragraphs 22 to 24 above, will not in and by themselves, cause any portion of the interest expense payable by A Co on the Note to W Co to be no longer deductible under paragraph 20(1)(c) of the Act.

The above ruling is 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 is binding provided the proposed transactions are completed on or before XXXXXXXXXX.

The ruling is based on the Act in its present form and does not take into account the effect of any proposed amendments to the Act.

Yours truly,

XXXXXXXXXX
For Director,
Financial Sector and Exempt Entities Division
Income tax Rulings Directorate
Policy and Planning Branch