12 February 1996 Income Tax Severed Letter 951791A - INTEREST DEDUCTIBILITY - IT-315

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:

Is It-315 applicable?

Position:

No

Reasons:

The sellers are also shareholders of Amalco. Transaction similar to a redemption.

See 913049

							February 12, 1996

	XXXXXXXXXX T.S.O.				HEADQUARTERS
G. Martineau
	Attention:  XXXXXXXXXX				(613) 957-8962
	            Business Audit
	            443-1-4
							7-951791

XXXXXXXXXX ("Amalco")

This is in reply to your memoranda dated July 5 and 27, 1995 and your memorandum dated November 17, 1995 with regards to additional information requested from the taxpayer on September 28, 1995.

Facts

XXXXXXXXXX

Your views

The gross proceeds of disposition on the sale of Oldco's shares should be $XXXXXXXXXX. Subparagraph 54(h)(i) of the Act mentions that the proceeds of disposition is the sale price. You are of the view that the vendors sold the shares of Oldco that would be free of debts.

If the proceeds is $XXXXXXXXXX it is your view that subsection 15(1) of the Act would apply for the Oldco debts that the sellers were responsible for and that were paid by Amalco.

The excess of the purchase price over the FMV determined by the XXXXXXXXXX Valuation Unit is subject to subsection 15(1) of the Act.

In your view, the interest paid by Amalco on the portion of the loan used to pay for the purchase price of the shares is not deductible. Amalco assumed unpaid purchase price of Newco for the Oldco shares that is neither borrowed money for the purpose of earning income from a business or property nor an amount payable for a property for the purpose of gaining or producing income therefrom or from a business.

Taxpayer's representative views

The sale price for the shares is $XXXXXXXXXX. The purchase price intended for the shares was calculated in utilizing the fair market value of the underlying asset of Oldco, $XXXXXXXXXX less the outstanding mortgage and taxes that might be payable on recapture depreciation.

XXXXXXXXXX of the Agreement provides that the sellers will assume all debts and liabilities of Oldco at the Closing date. In their view, this section does not include the mortgage but just the unforeseen liabilities that might accrue to the purchaser.

All the interest on the loan of $XXXXXXXXXX is deductible for Amalco for the following reasons:

1.The interest expense on the bridge construction loan of $XXXXXXXXXX was used by Newco to build a rental property and is a deductible expense.

2.Interest expense on the first mortgage was deductible for Oldco.

3.Management fees are a cost of constructing the rental property addition.

4.The purchase of Oldco shares was the purchase of an income asset. The FMV of the common shares of Oldco they established is reasonable and must be accepted by the Department. The full interest in the mortgage is a deductible expense for Amalco because it was laid out to earn business and property income.

Our comments

Purchase Price

The Agreement was for the sale of the common shares of Oldco. The sellers and the purchaser agreed that the purchase price of $XXXXXXXXXX would be payable and subject to adjustments. The representative argues that, accordingly, the proceeds of disposition is $XXXXXXXXXX.

From the wording of XXXXXXXXXX of the Agreement, we understand than an argument may be made that the purchase price and the proceeds of disposition would be $XXXXXXXXXX. If it is the case, the assumption and the payment of the debts of Oldco by the sellers would be considered as an outlay made for the purpose of making the disposition under subparagraph 40(1)(a)(i) of the Act. Amalco would have to borrow the $XXXXXXXXXX to pay the sellers who would use a portion of the receipt to pay the Oldco debts.

In our view, the fact that Amalco paid directly the debts of Oldco would not change the result that the net proceeds for the sellers is $XXXXXXXXXX mention that the purchase price is subject to adjustments because the amount of $XXXXXXXXXX reflected the FMV of the building owned by Oldco without considering the debts. In such a case, it seems reasonable to consider the purchase price equivalent to $XXXXXXXXXX that is the excess of the FMV of the building over the debts.

We are of the view that section 68 of the Act applies to reduce the proceeds of disposition for the shares of Oldco to the amount corresponding to the FMV established by the Valuation Unit that can reasonably be regarded as being the consideration for the disposition of the shares. The excess of the amount paid over the FMV represents funds appropriated from Newco and Amalco that is taxable in the hands of the sellers pursuant to subsection 15(1) of the Act. We do not comment on the amounts determined by the Valuation Unit.

Section 84.1 of the Act applies where an individual who resides in Canada disposes of capital property consisting of shares in a Canadian corporation (Oldco) to another corporation (Newco) in a non-arm's length transaction following which Oldco is connected with Newco within the meaning of subsection 186(4). Where an individual receives only non-share consideration, the excess of the consideration received over the greater of the paid-up capital or the adjusted cost base of the shares sold is deemed to be a dividend pursuant to subsection 84.1(1)(b) of the Act.

According to the facts submitted, the sellers and Newco are not related and, therefore, paragraph 215(1)(a) of the Act would not apply to deem them not to deal with each other at arm's length. Furthermore, there is no group of fewer than 6 persons that controlled Oldco and Newco for the purposes of paragraph 84.1(2)(b) of the Act. Consequently, subsection 84.1(1) would not apply except if you can demonstrate that the sellers were acting in concert without separate interest in respect of the sale of their shares in Oldco to Newco.

Paragraph 17 of IT-419R mentions that when two distinct parties act in a highly interdependent manner (in respect of a transaction of mutual interest), it can be assumed that the parties are acting in concert and therefore are not dealing with each other at arm's length. In the present case, the Oldco's shareholders did not subscribe in Newco's shares as stipulated in the subscription agreements executed in preparation of the transactions since the sale to Newco and the amalgamation occurred in a short period. However, the subscription was realized in Amalco. Even if the sellers did not become shareholders in Newco, we are of the view that this fact alone would not be sufficient in and by itself to conclude that Newco and the sellers were dealing at arm's length.

Interest Deductibility

Pursuant to paragraph 31 of IT-474R, a new corporation may deduct interest on borrowed money or an amount payable, for a property, of a predecessor corporation where such corporation was entitled to deduct interest on the borrowed money or the amount payable pursuant to paragraph 20(1)(c) of the Act and provided that the new corporation uses the borrowed money or the property for the purposes of earning income from a business or a property.

In the present situation, Amalco refinanced with the loan of $XXXXXXXXXX the first mortgage, the bridge construction loan and the management fees payable ("predecessor debts") that became its liabilities by virtue of the amalgation. In our view, subsection 20(3) of the Act applies to the portion of the loan (the "Portion") used to replace the predecessor debts. Consequently, the Portion shall be deemed to have been used for the purpose for which the first mortgage and the bridge construction loan were used, or to acquire the addition to the rental property in respect of which the amount of the management fees were payable. The interest payable on the Portion are deductible to the extent that this Portion is used by Amalco to earn income from its business or a property, the rental building.

In our view, the position stated in the IT-315 does not apply to the portion of the $XXXXXXXXXX loan ($XXXXXXXXXX) (the "Payment") distributed by Amalco to Oldco shareholders. It is our view that the Payment distributed by Amalco to Oldco shareholders is an amount used by Amalco to return the paid-up capital ("PUC") on the common shares and the retained earnings of Oldco. Therefore, the interest deductibility on the Payment is equal to the portion representing a return of the PUC of the Oldco shares and the retained earnings of Oldco to the extent that the PUC and the retained earnings had been used for the purpose of earning income from a business or a property (other than property the income from which would be exempt or that is an interest in a life insurance policy).

In our view, the transactions realized by the sellers and Newco must be analyzed with the obiter comments by Former Chief Justice Dickson in Bronfman, (1987) 1 C.T.C. 117 (S.C.C.) at page 128:

"Assessment of taxpayers' transactions with an eye to commercial and economic realities, rather than juristic classification of form, may help to avoid the inequity of tax liability being dependent upon the taxpayer's sophistication at manipulating a sequence of events to achieve a patina of compliance with the apparent prerequisites for a tax deduction."

We are of the view that our position stated on page 607 of the 1979 Round Table applies in this situation. The Department mentioned that interest on monies borrowed to redeem shares would be deductible to the extent that the test in paragraph 3 of IT-80 is met with respect to the portion of the payment representing a return of the PUC and that the excluding tests in par. 5 of IT-80 would not apply with respect to the balance of the payment.It is the Department practice that a deficit would not reduce capital and to allow the interest deductibility to the extent of the PUC, where the distributing company is in deficit position.

In the present case, the result of the transactions is to distribute the PUC, that is a qualifying use, the plus value and an appropriation of funds that are not qualifying uses for the purposes of paragraph 20(1)(c) of the Act.

It is our view that the adjusted equity method set out in section 20.2 of the Draft Legislation of December 20, 1991 on the tax treatment of the interest expense (the "Draft Legislation") does not apply in this case because the Draft Legislation is a discussion paper and the administrative positions existing at the date of its publication continue to apply until the introduction of the final legislation as stated in the release 91-141 (copy enclosed) issued by the Department of Finance.

We hope that our comments will be helpful.

Section Chief
Financing, Leasing and Deferred Plans Section
Financial Industries Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch