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: Can a corporation, when determining whether interest is deductible on money borrowed to pay a dividend, ignore, that is, reverse, a reduction to retained earnings caused by the application paragraphs .08 and .09 of Section 3840 of the CICA Handbook to a taxable-related-party transaction?
Position: Generally no, but not enough information to conclude on the application of the "fill the hole" concept.
Reasons: Matter should be determined in the context of an advance income tax ruling request submitted in accordance with IC 70-6R5 or, if the transaction is completed, by submission to the appropriate TSO.
XXXXXXXXXX 2007-022893
L. Carruthers, CA
September 12, 2008
Dear XXXXXXXXXX :
Re: Interest Deductibility - Money Borrowed to Pay Dividend
This is in reply to your letter of March 26, 2007, and further to our telephone conversation (Carruthers/XXXXXXXXXX ) of September 4, 2007, wherein you requested our technical interpretation of the meaning of retained earnings, or accumulated profits, for the purpose of determining whether interest was deductible on money borrowed to pay a dividend pursuant to paragraph 20(1)(c) of the Income Tax Act (the "Act"). We apologize for our delay in responding.
In the assumed fact scenario you presented, the application of paragraphs .08 and .09 of Section 3840 of the CICA Handbook (the "Handbook") to a taxable-related-party transfer of property at a gain resulted in the retained earnings of the recipient corporation being reduced for financial statement purposes. The reduction results from the Handbook requirements that a related party transaction be measured at the carrying amount. Consequently, the recording of the taxable-related-party transaction resulted in the recipient corporation showing a retained deficit for financial statement purposes.
You requested clarification as to whether the recipient corporation could, when determining whether interest was deductible on money borrowed to pay a dividend, ignore, that is, reverse, this reduction to retained earnings caused by the application of paragraphs .08 and .09 of Section 3840 of the Handbook to this taxable-related-party transaction.
Our Comments
The facts in your letter appear to relate to a factual situation involving specific taxpayers. As explained in Information Circular IC-70-6R3, 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. Furthermore, should your situation involve specific taxpayers and a completed transaction, you should submit all relevant facts and documentation to the appropriate tax services office for their views. Nevertheless, we offer the following comments in connection with your request. These comments are of a general nature only.
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, in Bronfman 87 DTC 5059, 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. 70 DTC 6351 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 borrowed money to "fill the hole" of capital withdrawn from the corporation's business is a key element of this concept. The "fill the hole" concept requires the determination of the amount of capital used by the corporation for the eligible purpose of earning income prior to the replacement of that capital with borrowed money. As noted in paragraph 23 of Interpretation Bulletin IT-533, Interest Deductibility and Related Issues, capital includes the contributed capital and accumulated profits of a corporation.
Borrowing to pay dividends is an ineligible direct use, but interest deductibility in such situations may be allowed under the exceptional circumstances category, consistent with the concept of borrowing to "fill the hole". As noted in paragraph 23 of IT-533, the CRA generally accepts this category of exceptional circumstances, and generally accepts accumulated profits as the appropriate measurement of the hole that may be filled with borrowed money used to pay a dividend. Furthermore, in Chase Manhattan 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.
With respect to the assumed fact scenario you presented, to determine whether borrowed money "fills the hole" of the recipient corporation's accumulated profits previously used for eligible purposes, the CRA would be required to examine, among other things, the accounting method used by the transferor and transferee to record the taxable-related-party transaction as well as the effect on the corporate group's combined capital before and after the transaction. Your enquiry, in our view, would best be dealt with in the context of an advance income tax ruling request or, if the transaction is completed, by the appropriate TSO, such that we would have the opportunity to fully review all of the facts and relevant agreements. Nevertheless, we are prepared to offer the following general comments with respect to taxable-related-party transactions.
As noted in the following excerpt from paragraph 23 of IT-533, where property is transferred between related corporations at a gain, generally, the gain would not be reflected in the parties' accumulated profits. "Generally, accumulated profits can reflect transactions arising in the ordinary course of business between non-arm's length parties. The impact on accumulated profits of other non-arm's length transactions must be examined on the basis of the particular facts involved."
In our view, there are no circumstances present in the assumed fact scenario presented which would cause this general position to be altered. Therefore, in our view, the recipient corporation in the assumed fact scenario could not, when determining whether interest was deductible on money borrowed to pay a dividend, ignore, that is, reverse, the reduction to retained earnings caused by the application of paragraphs .08 and .09 of Section 3840 of the CICA Handbook to the taxable-related-party transfer of property.
We trust that our comments will be of assistance.
Yours truly,
R.A. Albert, CA
For Director
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate
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