2007 Ruling 2006-0216551R3 - 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 property?

Position: YES

Reasons: Substituted Property - paragraph 27 of IT 533

XXXXXXXXXX 								2006-021655

XXXXXXXXXX, 2007

Dear XXXXXXXXXX:

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

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.

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 A Co or a related person;

(iv) the subject of a ruling previously issued by the Income Tax Rulings Directorate to A Co or a related person; nor

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

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

All amounts used in this letter are expressed in Canadian dollars unless otherwise provided.

DEFINITIONS

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

(a) "A Co" means XXXXXXXXXX, as described in 3 and 4 below;

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

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

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

(e) "B Co" means XXXXXXXXXX as described in 5 below;

(f) "B Co Shares" means shares of B Co as described in 6 below;

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

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

(i) "E Co" means XXXXXXXXXX as described in 5 below;

(j) "E Co Leasing" means XXXXXXXXXX, a subsidiary of E Co Holdco as described in 5 below;

(k) "E Co Holdco" means XXXXXXXXXX, a subsidiary of E Co as described in 5 below;

(l) "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;

(m) "Finance Co" means XXXXXXXXXX, a wholly-owned subsidiary of A Co;

(n) "New B Co" means a newly incorporated company under the laws of XXXXXXXXXX as described in 14 below:

(o) "New Canco" means a newly incorporated company as described in 13 below;

(p) "New LP" means XXXXXXXXXX, Limited Partnership, a limited partnership as described in 8 below;

(q) "Note" means a promissory note issued by A Co to W Co as described in 6 below;

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

(s) "Previous Ruling Request" means the taxpayer's written request for an advance income tax ruling dated XXXXXXXXXX, the taxpayer's letter dated XXXXXXXXXX, with additional information relating to the original request, and the Ruling (2005-015225) dated XXXXXXXXXX, 2005;

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

(u) "Proposed Transactions" means the proposed transactions described in 13 to 19 below;

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

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

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

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

(z) "Transferred Shares" has the meaning described in 6 below;

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

(bb) "US LLC" means a newly formed limited liability company as described in 15 below;

(cc) "W Co" means XXXXXXXXXX as described in 2 below;

(dd) "X Co" means XXXXXXXXXX as described in 1 below; and,

(ee) "X Group" means XXXXXXXXXX and entities related to it.

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. 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. B Co's principal asset is all of the issued and outstanding shares of the X Group's principal XXXXXXXXXX operating company, E Co. 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 E Co Holdco, a company incorporated under the laws of XXXXXXXXXX. E Co Holdco owns all the shares of E Co Leasing, a company that carries on the business of leasing XXXXXXXXXX.

6. On XXXXXXXXXX, A Co acquired the shares of various companies (the "Transferred Shares") from W Co, including XXXXXXXXXX% of the B Co shares. A Co issued to W Co a secured promissory note (the "Note") and additional common shares of A Co as consideration. One of the objectives of the transactions was the consolidation, under A Co, of the non-U.S. "Americas" corporations (i.e., Canada and XXXXXXXXXX).

7. A Co entered into certain transactions related to the ownership of the B Shares. These transactions were the subject of the Previous Ruling Request and are described in 8 to 12 below.

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

9. On XXXXXXXXXX, A Co and Finance Co entered into a share transfer agreement under which A Co transferred XXXXXXXXXX% of the B Co Shares to Finance Co for consideration equal to the fair market value of XXXXXXXXXX% of the B Co Shares. The consideration provided by Finance Co was common shares of Finance Co with a fair market value equal to the fair market value of XXXXXXXXXX % of the B Co Shares. A Co and Finance Co jointly elected 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.

10. On XXXXXXXXXX, Finance Co transferred the above XXXXXXXXXX% of the B Co Shares to New LP in exchange for a XXXXXXXXXX% partnership interest.

11. On XXXXXXXXXX, A Co transferred the remaining XXXXXXXXXX% of the B Co Shares to New LP in exchange for a XXXXXXXXXX% partnership interest. A Co, Finance Co and New LP jointly elected pursuant to subsection 97(2) of the Act, in prescribed form and 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 Finance Co, respectively of the B Co Shares.

12. Interest payable by A Co on the Note was, and continues to be deducted pursuant to subparagraph 20(1)(c)(ii) of the Act and no portion is precluded from being deductible pursuant to section 67 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 continues to be deductible pursuant to subparagraph 20(1)(c)(ii) after the substitution of that property (as described in 9 and 11 above) with the shares of Finance Co and the interest in New LP, and no portion is precluded from being deductible pursuant to section 67 of the Act 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 subsequently replaced with the shares of Finance Co and the partnership interest in New LP (the substituted property), representing property acquired for the purpose of gaining or producing income from property (other than property from which the income would be exempt or property that is an interest in a life insurance policy), 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.

PROPOSED TRANSACTIONS

13. New LP will form New Canco, a limited liability company under the laws of a province of Canada or under the CBCA.

14. New Canco will form New B Co, a company incorporated under the laws of XXXXXXXXXX.

15. New B Co will form US LLC, a new limited liability company under the laws of the United States. US LLC will be formed without issuing an initial member interest.

16. New LP and New Canco will enter into a share transfer agreement under which New Canco will agree to acquire from New LP, and New LP will agree to transfer to New Canco, XXXXXXXXXX% of the B Co Shares for consideration equal to the fair market value of the B Co Shares. The consideration provided by New Canco for the B Co Shares will be the issuance and delivery of common shares of New Canco with a fair market value equal to the fair market value of the B Co Shares. It is intended that pursuant to subsection 85(2) of the Act, New Canco, A Co, and Finance Co will jointly elect in prescribed form and within the time referred to in subsection 85(6) of the Act for the transfer to occur at the adjusted cost base to New LP of the B Co Shares.

17. New Canco and New B Co will enter into a share transfer agreement under which New B Co will agree to acquire from New Canco, and New Canco will agree to transfer to New B Co, XXXXXXXXXX% of the B Co Shares for consideration equal to the fair market value of the B Co Shares. The consideration provided by New B Co for the B Co Shares will be the issuance and delivery of common shares of New B Co with a fair market value equal to the fair market value of the B Co Shares. It is intended that subsection 85.1(3) of the Act will be applicable to the transfer of the B Co Shares to New B Co.

18. New B Co and US LLC will enter into a share transfer agreement under which US LLC will agree to acquire from New B Co, and New B Co will agree to transfer to US LLC, XXXXXXXXXX% of the B Co Shares for consideration equal to the fair market value of the B Co Shares. The consideration provided by US LLC for the B Co Shares will be the allocation of the initial member interest of US LLC with a fair market value equal to the fair market value of the B Co Shares. It is intended that paragraph 95(2)(c) of the Act will be applicable to the transfer of the B Co Shares to US LLC.

19. B Co will liquidate into US LLC under the laws of XXXXXXXXXX. Pursuant to paragraph 95(2)(e.1) of the Act as it is currently drafted, it is expected that the disposition of the shares of E Co by B Co in the course of the liquidation will occur at the adjusted cost base of the shares of E Co to B Co. It is not expected that the proposed amendments to paragraph 95(2)(e.1) of the Act will change the tax treatment of the distribution by B Co of the shares of E Co in the course of the liquidation of B Co.

PURPOSE OF THE PRPOSED TRANSACTIONS

20. There is a tax incentive available under XXXXXXXXXX tax law for capital investment in XXXXXXXXXX. This incentive is referred to hereafter as "Interest on Equity". For the purposes of this incentive, the invested capital and retained earnings of a XXXXXXXXXX corporation are treated as equivalent to the principal amount of a notional loan from the shareholder. Notional interest expense is then calculated by applying a specified interest rate to the notional principal amount. Subject to certain limitations, the XXXXXXXXXX corporation is allowed to treat the calculated amount as the equivalent of deductible interest expense for XXXXXXXXXX tax purposes.

21. To obtain a deduction for Interest on Equity, the XXXXXXXXXX corporation must distribute to its shareholder an amount computed as Interest on Equity. The distribution must be declared by the Board of Directors and is subject to withholding tax in XXXXXXXXXX. The generally applicable rate of withholding tax is XXXXXXXXXX%. However, such distributions paid to corporations organized in certain jurisdictions, including XXXXXXXXXX, are subject to XXXXXXXXXX withholding tax at a XXXXXXXXXX% rate.

22. E Co intends to claim a deduction for Interest on Equity in the future. To be eligible for the XXXXXXXXXX% rate of withholding tax under XXXXXXXXXX law, the ownership of E Co must be changed. The transfer of ownership of E Co to US LLC is expected to result in the application of the XXXXXXXXXX% rate of XXXXXXXXXX withholding tax to distributions by E Co under these provisions.

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 ruling is set forth below:

The Proposed Transactions as described in paragraphs 13 to 19 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 no longer be 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.

Unless otherwise confirmed in the above ruling, nothing in this letter should be construed as implying that the CRA has confirmed, reviewed or has made any determination in respect of:

(a) the determination of the adjusted cost base, paid-up capital or fair market value of any shares referred to herein; or

(b) any tax consequences relating to the facts, and Proposed Transactions described herein other than those described in the ruling given above.

For greater certainty, our ruling should not be construed as providing comfort that we have reviewed or approved any of the proposed share transfers intended to have section 85 or section 95 of the Act apply.

Yours truly,

XXXXXXXXXX
For Director
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch