13 August 2012 Internal T.I. 2012-0453481I7 - Accumulated Profits

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: Where Canco uses borrowed money, commingled with cash on hand, to fund a dividend in excess of its accumulated profits, to what extent may the taxpayer deduct interest on the borrowed money?

Position: Given the facts as we understand them to be, $XXXXXXXXXX of the borrowed money could be traced to the in-direct eligible use of filling the hole.

Reasons: Canco may link a portion of the borrowed money, commingled with cash on hand and used for the purposes of paying a dividend in excess of its accumulated profits, to the eligible use of filling the hole created upon the distribution of its accumulated profits; and where the dividend is paid in instalments, the better view is that each commingled dollar used to reduce the dividend payable would first go to fill the hole created on the declaration of the dividend, followed by the payment of the portion of the dividend in excess of accumulated profits.

August 13, 2012

XXXXXXXXXX Tax Services Office HEADQUARTERS
Large Business Audit Income Tax Rulings
Large File Case Directorate
XXXXXXXXXX, Manager L. Carruthers, CA
(613) 957-2060

2012-045348

XXXXXXXXXX (“Canco”)
Impact of Borrowed Money being Commingled with Cash on Hand and Used to Fund a Dividend in excess of Canco’s Accumulated Profits

We are writing in response to your e-mail dated June 26, 2012, and further to your letter to the above-noted taxpayer dated September 23, 2011, and their written response to you dated XXXXXXXXXX.

It is our understanding that the following transactions took place on XXXXXXXXXX, that being XXXXXXXXXX days prior to Canco's year ended XXXXXXXXXX:

1. A subsidiary of Canco (“Subco”) declared a $XXXXXXXXXX dividend payable to Canco (the “Subco dividend”). Immediately before the Subco Dividend was declared, Subco’s accumulated profits, as that term is described in paragraph 23 Interpretation Bulletin IT-533, entitled Interest Deductibility and Related Issues (“APs”), were approximately $XXXXXXXXXX.

2. Canco declared a $XXXXXXXXXX dividend payable (the “Canco Dividend”) to its corporate parent (“Parentco”). Following the declaration of the Subco Dividend and immediately before the Canco Dividend was declared, Canco’s APs were approximately $XXXXXXXXXX which included Canco’s allocated share of its partnerships’ incomes, less losses, for each fiscal period end of the partnerships ending before the dividend was declared. Therefore, the Canco Dividend was approximately $XXXXXXXXXX greater than Canco’s APs immediately before the Canco Dividend was declared.

3. In five sequential transactions:

a. Subco paid XXXXXXXXXX of the $XXXXXXXXXX Subco Dividend payable to Canco;

b. Canco deposited the cash proceeds from the Subco Dividend into bank account X;

c. Canco borrowed XXXXXXXXXX of $XXXXXXXXXX from a partnership which it was a partner of;

d. Canco deposited the cash proceeds from the borrowing into bank account X; and

e. Canco, by withdrawing funds from bank account X, paid XXXXXXXXXX of the $XXXXXXXXXX Canco Dividend payable to Parentco.

It is our further understanding that transaction 3c. above was the second last transaction in five sequential implementations of a XXXXXXXXXX-step series of transactions. Each XXXXXXXXXX-step series of transactions began with Parentco drawing down on its line of credit and culminated in Parentco repaying that line of credit. I.E., there was a circular flow of money which, inter alia, resulted in Canco owing XXXXXXXXXX X $XXXXXXXXXX = $XXXXXXXXXX (the “Borrowed Money”) to a partnership which it was a partner of.

The Taxpayer’s View

In their letter dated XXXXXXXXXX, the taxpayer’s representatives presented their views as follows:

XXXXXXXXXX

Our Comments

It appears that the taxpayer’s above view is based on their understanding of paragraph 20 of IT-533 which reads as follows:

“Frequently, the cash damming technique described in ¶ 16 is not followed or available and borrowed money is deposited to one account and commingled with other cash. In such situations, tracing/linking is problematic since cash is fungible and taxpayers are unable to trace the funds to identifiable uses. However, taxpayers are entitled to apply the flexible approach to tracing/linking described in ¶ 18 in such situations. Consequently, where borrowed money and other money is commingled, taxpayers may choose the uses of the borrowed money from all of the uses of the money. The same approach would also be applicable to lines of credit and other similar arrangements. The timing of transactions is relevant for this linking exercise as

• this approach is only applicable for times when borrowed money and other money is commingled, and
• a specific use of money can never be linked to a borrowing that occurs subsequently.

Generally, however, there is no timing issue for transactions occurring on the same day.”

We agree that the first paragraph above has relevance to the determination of the use of the Borrowed Money by Canco, however, we do not agree that the second paragraph does. It is our understanding that Canco was prohibited by real economic factors from paying off the Canco Dividend payable in one payment which, therefore, resulted in the five sequential transactions described in 3 above. The courts have noted on many occasions that a taxpayer cannot be assessed based on transactions it could have done but, rather, it is to be assessed based on the transactions it did do. It would be even more challenging, in our view, for a taxpayer to support why it should be assessed based on transactions it was unable to do.

It remains our view, as it was described in your letter to the taxpayer dated September 23, 2011, that the better view is that where a dividend in excess of APs is paid in instalments, each dollar used to reduce the dividend payable would first go to the fill the hole created on the declaration of the dividend, followed by the payment of the portion of the dividend, if any, in excess of APs. This would, in our view, result in the most logical outcome and is supported by the simple number line: where one starts at +135, one must pass through +134, +133…0…-90 and -91 before getting to -92.

The taxpayer’s view that all of the interest on the Borrowed Money should be deductible in full does not, in our view, respect the fact that each instalment payment of the Canco Dividend payable was a unique transaction. Their view would require a deficit to be recognized (corresponding to the portion of the declared dividend in excess of APs) prior to all of Canco’s retained earnings (the portion of the declared dividend approximating APs) being paid out.

In conclusion, in our view, Canco may link a portion of the Borrowed Money commingled with cash on hand and used for the purpose of paying the Canco Dividend to the eligible use of filling the hole created upon its distribution of its APs. Furthermore, because the Canco Dividend was paid in instalments, the better view is that each dollar used to reduce the Canco Dividend payable would first go to fill the hole created on the declaration of the Canco Dividend, followed by the payment of the portion of the Canco Dividend in excess of APs.

Given the facts as we understand them to be, the result would be that approximately $XXXXXXXXXX of the Borrowed Money would have been used for the in-direct eligible use of the filling the hole.

To follow is a mathematical description of our view.

XXXXXXXXXX

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the electronic library version, or they may request a severed copy using the Privacy Act criteria, which does not remove client identity. You should make requests for this latter version to Ms. Celine Charbonneau at (613) 952-1361. A copy would be sent to you for delivery to the client.

Doug Watson
for Director
Financial Industries Division
Income Tax Rulings Directorate