27 May 1988 Income Tax Severed Letter 5-5976 - [June 2, 1987 Notice of Ways and Means Motion on Interest Deductibility ("Motion")]

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.

Peter Lee (613)957-2745

May 27, 1988

Dear Sirs

Re: June 2, 1987 Notice of Ways and Means Motion on Interest Deductibility ("Motion")

We are writing in reply to your letter of April 28, 1988 wherein you requested our view with respect to the deductibility of interest on money borrowed in the following hypothetical situation.

1. Company C incorporates a wholly owned subsidiary, Company D. Company C transfers some business assets to Company D, electing pursuant to subsection 85tl) of the Income Tax Act ("Act"). The aggregate elected amount under subsection 85(1) of the Ace in respect of the transferred assets equals their aggregate cost of $100,000. The fair market value of the transferred assets is $700,000. In consideration for the transferred assets Company D issues shares having a fair market value of $700,000 and stated capital of $700,000 to Company C. The shares will be the only issued ant outstanding shares of Company D. By virtue of subsection 85(2.1) of the Act the paid-up capital of the shares issued to Company C will be $100,000 ("revised paid-up capital"). Company D will use all of its assets in carrying on business in Canada.

2.Company D borrows $650,000 from an arm's length third party. Company D pays the $650,000 to Company C on a reduction, by $650,000, of the stated capital of its shares held by Company C. By virtue Of 6ubseetion 84(4) of the Act, Company D will be teemed to have paid, and Company C will be deemed to have received, a dividend equal to $550,000.

It has been proposed in the Motion that the expression "borrowed money used for the purpose of earning income from a business or property" will include any borrowed money used by a corporation to return capital to its shareholders to the extent that such capital was used by the corporation for a qualifying purpose. In the situation described above, it is our view that the deemed dividend that arises on reduction of the stated capital would not be considered a return Of capital to Company C, to the extent of the "appraisal surplus" on which tax was deferred : on the non-arm' a length transfer of assets. Therefore, the interest which Company D will pay in respect of the above-noted indebtedness would be deductible only to the extent of interest on the amount of revised paid-up capital.

We hope that our above-noted view is helpful to you. Our opinion is not an advance income tax ruling and accordingly is not binding on the Department.

Yours truly,

for Director Financial Industries Division Rulings Directorate