26 April 1995 CTF Roundtable Q. 16, 9511520 - INTEREST DEDUCTIBILITY - PREFERRED SHARES

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

Whether interest would be deductible in full where borrowed money is used to acquire preferred shares and the interest rate on the indebtedness exceeds the dividend rate on the shares?

Position TAKEN:

Interest would be allowable only to the extent of the dividend income.

Reasons FOR POSITION TAKEN:

This is our longstanding position. Consistent with draft legislation.

Revenue Canada Round Table
Tax Executive Institute Conference
May 7-10, 1995

Question 16

DISTRESS PREFERRED SHARES - TAX RULINGS

We are aware that favourable rulings with respect to the status of distress preferred shares have been given in circumstances where it is contemplated that some or all of the shares will ultimately be held by parties other than the existing lender or lenders to the creditor corporation which is in financial difficulty.

We understand that taxpayers have been discouraged from seeking rulings that interest paid on money borrowed by "Third Party Purchasers" to finance the acquisition of the distress preferred shares from the existing lenders will be deductible in full under paragraph 20(1)(c) if the dividend rate receivable on the shares is less than the interest rate payable on the borrowed funds. Lack of favourable rulings with respect to interest deductibility has discouraged some potential investors from entering the market for these shares, reducing demand for the shares and increasing the dividend rate that must ultimately be borne by the corporation in financial difficulty.

Can you comment on the reasons that Rulings is reluctant to give favourable rulings in these circumstances?

Department's position

The Department's longstanding general position, as stated in response to Q. 3 of the 1979 Canadian Tax Foundation Revenue Canada Round Table, is that "interest expense resulting from a loan used by a corporation to acquire preferred shares is fully deductible only if the rate of interest expense is equal to or less than the rate of return on the preferred shares". If this is not the case, then the interest expense in a given year will be restricted to the dividends actually received in that year. This position is now reflected in draft paragraph 20(1)(qq) of the Act, outlined in the Department of Finance Information #91-141, dated December 20, 1991. The following quote from Explanatory Notes from the same document make the intent of the draft legislation clear:

"This paragraph would typically apply in the context of shares bearing a fixed dividend rate that is lower than the interest rate charged on the funds borrowed to acquire those shares."

Author: A. Nelson
File: 951152
Date: April 26, 1995