12 July 2010 External T.I. 2009-0344721E5 - Interest Deductibility

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: 1. Is a subsidiary entitled to deduct reasonable interest incurred on borrowed money used to pay a dividend to its parent which used the proceeds to acquire an interest in an annuity contract in respect of which section 12.2 applies? 2. Where a subsidiary and its parent amalgamate, is Amalco entitled to deduct, without limitation, reasonable interest incurred on money previously borrowed by the subsidiary and used to pay a dividend to the parent, which used the proceeds to acquire an interest in an annuity contract in respect of which section 12.2 applies?

Position: 1. Dependent on the facts. GAAR could apply. 2. No, the allowable deduction would be limited by subparagraph 20(1)(c)(iv).

Reasons: 1. The exception to the direct use test regarding borrowed money used to pay a dividend may not be met. Dependent on the facts, the borrowing and the dividend payment could be within a series of transactions to which section 245 of the Act would apply. 2. Amalco's current use of the borrowed money would be to acquire an interest in an annuity contract in respect of which section 12.2 applies.

XXXXXXXXXX
									2009-034472
									L. Carruthers, CA

July 12, 2010

Dear XXXXXXXXXX :

Re: Interest Deductibility

This is in reply to your letter of October 13, 2009, wherein you asked our assistance to clarify the interest deduction that would be allowed in a particular scenario, pursuant to the Income Tax Act (the "Act"). The particular scenario you presented is as follows:

1. Company B is wholly-owned by Company A. Both are Canadian-controlled private corporations, as defined in subsection 125(7).

2. Company B has retained earnings of $1 million, reflecting the results of arm's length transactions in the ordinary course of business.

3. Company B borrows $1 million (the "Borrowing") from an arm's length lender and uses the borrowed funds to pay a regular taxable dividend to its parent, Company A.

4. Company A uses the cash represented by the dividend to immediately purchase an annuity on the life of a related individual. Section 12.2 is applicable to the annuity.

5. Several years after the transactions in 3 and 4 above are carried out, Company A and Company B amalgamate (to form "Amalco") for business reasons not connected in any manner to those two transactions. The amalgamation meets all the parameters set out in subsection 87(1).

Our Comments

Your request appears to be an actual fact situation relating to a proposed transaction. Written confirmation of the tax implications inherent in an actual proposed transaction is given by this Directorate only where the transactions are the subject of an advance income tax ruling request submitted in a manner set out in Information Circular 70-6R5. As stated in paragraph 22 of IC 70-6R5, written opinions are not advance tax rulings and, accordingly, are not binding on the Canada Revenue Agency (the "CRA"). The following comments are, therefore, of a general nature only.

Interest Deductibility by Company B

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 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.

Borrowing to pay a dividend is an ineligible direct use, but interest deductibility in such situations may be provided under the exceptional circumstances category, consistent with the concept of borrowing to replace capital to "fill the hole" as discussed in Trans-Prairie Pipelines Ltd.. We generally accept this category of exceptional circumstances and generally accept accumulated profits as the appropriate measurement of the hole that may be filled with the 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, would not be deductible. Whether it would be appropriate to apply our general position concerning money borrowed to pay dividends to a situation such as the one described in your letter, would have to be determined after reviewing all the circumstances relevant to an actual situation.

Furthermore, in the context of the scenario described, notwithstanding that the use of borrowed money to pay a dividend not greater than the payor's accumulated profits would generally be an exception to the direct use test, all relevant details would need to be considered to ensure that the Borrowing and the purchase of an annuity was not within a series of transactions to which section 245 of the Act applied. For example, one of the facts of particular interest in the scenario described would be whether the corporate structure described was established within a series of transactions which included Company B borrowing money and Company A acquiring an annuity.

Interest Deductibility by Amalco

Pursuant to subsection 87(7) of the Act, where the amalgamation of two or more corporations results in the amalgamated corporation being liable for a predecessor's borrowed money and the amount payable by the amalgamated corporation on maturity of that debt is the same as what would have been payable by the predecessor on maturity, the provisions of the Act do not apply with respect to the transfer of the debt, and the amalgamated corporation is to be treated as if it had borrowed the money at the time the money had been borrowed by the predecessor.

Where a predecessor corporation was entitled, under paragraph 20(1)(c) of the Act, to deduct interest on borrowed money, such deduction, in our view, would not be denied to the amalgamated corporation provided the borrowed money continues to be used by the amalgamated corporation as required by that paragraph. Paragraph 20(1)(c) of the Act provides, notably, that the money must have been borrowed for the purpose of gaining or producing income from a business or property.

The Supreme Court of Canada decision in The Queen v. Phyllis Barbara Bronfman Trust [87 DTC 5059] confirmed that it is the current use made of the borrowed funds in a particular year, rather than the original use of the funds, which must be considered in determining whether the interest paid or payable with respect to the borrowed funds is deductible in a particular year. Therefore, in order to determine whether borrowed money has been put to an eligible use in a particular year, it is necessary to determine the current use of the original borrowed money.

In the scenario described, in our view, Amalco's current use of the borrowed money would be to acquire an interest in an annuity contract in respect of which section 12.2 of the Act applies and, therefore, in our view, Amalco's allowable deduction regarding interest on the Borrowing would be limited by subparagraph 20(1)(c)(iv) of the Act.

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