23 March 2010 Internal T.I. 2009-0348551I7 - 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: Can the corporation, when determining whether interest is deductible on money borrowed to pay a dividend, ignore, that is reverse, a reduction to retained earnings caused by the application of paragraphs .08 and .09 of Section 3840 of the CICA Handbook to a taxable related party transaction?

Position: Yes

Reasons: Under the circumstances, the corporation's accumulated profits should not be affected by the related party transaction.

								March 23, 2010

	MONTRÉAL TAX SERVICES OFFICE			HEADQUARTERS
	Claude Guilmain					L. Carruthers, CA

Audits of Large Businesses

	305 René-Lévesque West
	Montréal, QC  H2Z 1A6
								2009-034855

XXXXXXXXXX
Money Borrowed to Pay Dividends

This is in reply to your phone call of August 5, 2009, wherein you asked that we comment on an expected submission from XXXXXXXXXX ("Aco's") representative regarding the interpretation of paragraph 23 of Interpretation Bulletin IT-533, as it relates to the deductibility of interest on money borrowed by Aco to pay dividends to its corporate parent, XXXXXXXXXX ("Parentco").

Based on the representative's submissions of November 19, 2009, and additional information received from you on January 27, 2010, our understanding of the relevant transactions is as follows:

XXXXXXXXXX : By way of a public share offer, Parentco acquired all of the issued and outstanding shares of XXXXXXXXXX . ("Targetco").

XXXXXXXXXX : Parentco transferred all the shares it held in Targetco to another of its wholly-owned corporations ("Acquireco").

Targetco amalgamated with Acquireco to form Amalco.

In accordance with subparagraph 88(1)(d) of the Income Tax Act, Amalco made a designation to bump the cost of certain properties, including shares it held of XXXXXXXXXX. ("Subco1") and XXXXXXXXXX ("Subco2"). This designation had no effect on the accounting cost of these shares.

XXXXXXXXXX : Amalco transferred all the shares it held in Subco1 to Aco for consideration equal to their fair market value ("FMV"). In exchange, Aco issued, to Amalco, preferred shares redeemable for $XXXXXXXXXX and a promissory note of $XXXXXXXXXX.

The Subco1 shares had an accounting cost of $XXXXXXXXXX and, for accounting purposes, the transaction was recorded in Aco's and Amalco's books, respectively, as follows:

DR CR

Investment Subco1 $ XXXXXXXXXX

Retained earnings $XXXXXXXXXX

Promissory Note payable to Amalco $XXXXXXXXX

Share Capital $XXXXXXXXX

Promissory Note receivable from Aco $XXXXXXXXXX

Investment Aco $XXXXXXXXXX

Investment Subco1 $XXXXXXXXX

Contributed surplus $XXXXXXXXX

XXXXXXXXXX : Amalco was wound up into Parentco.

XXXXXXXXXX : Parentco transferred all the shares it held in Subco2 to Aco for consideration equal to their FMV. In exchange, Aco issued, to Parentco, preferred shares redeemable for $XXXXXXXXXX.

The Subco2 shares had an accounting cost of $XXXXXXXXXX and, for accounting purposes, the transaction was recorded in Aco's and Parent's books, respectively, as follows:

DR CR

Investment Subco2 $ XXXXXXXXXX

Retained earnings $ XXXXXXXXXX

Share Capital $ XXXXXXXXX

Investment Aco $ XXXXXXXXXX

Investment Subco2 $XXXXXXXX

Contributed surplus $ XXXXXXXXX

As noted above, it is our understanding that the application of paragraphs 3840.08 and 3840.09 of the CICA Handbook (herein "by the application of the Handbook") to the XXXXXXXXXX , and XXXXXXXXXX , transfers of shares to Aco (herein "the Transactions") resulted in the retained earnings of Aco being reduced for financial statement purposes.

Taxpayer's Position

In Aco's case, the retained earnings earned prior to the Transactions have not been distributed or otherwise depleted in the commercial sense as a result of the Transactions and, therefore, the subject interest deduction should not be disallowed as a result of the reductions to Aco's retained earnings as noted above.

Your Position

Your view is that when determining whether interest was deductible on money borrowed to pay a dividend to Parentco, Aco could not ignore (i.e., not reverse) a reduction to retained earnings caused by the application of the Handbook to the Transactions.

This view is based on our prior comments on the subject as expressed in external interpretation 2007-022893.

Our Comments

Borrowing to pay dividends 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. 70 DTC 6351. 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 (see 2002-017694). 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, is not deductible.

CRA's current interpretative position, as described in paragraph 23 of IT-533, is that:

"Interest expense on borrowed money used to redeem shares or return capital can be an exception to the direct use test. In connection with this use, the purpose test will be met if the borrowed money replaces capital (contributed capital or accumulated profits) that was being used for purposes that would have qualified for interest deductibility had the capital been borrowed money (eligible purposes). Consistent with the concept of filling the hole, contributed capital generally means the funds provided by the shareholders to commence, or otherwise further, the carrying on of the business. While in most situations the legal or stated capital for corporate law purposes would be the best measurement of contributed capital for this purpose, other measurements may be more appropriate depending on the circumstances. In situations where some proportion of shares is being replaced with borrowed money, only the capital of those shares, computed on a pro-rata basis, would be considered to be replaced with the borrowed money. A corporation's deficit does not reduce contributed capital for purposes of this exception.

Similarly, with regard to the payment of dividends (including deemed dividends), borrowed money used to replace the accumulated profits of a corporation that have been retained and used for eligible purposes can be an exception to the direct use test. Accumulated profits would generally be the retained earnings of the corporation computed on an unconsolidated basis with investments accounted for on a cost basis. The accumulated profits of a corporation do not track any particular shareholdings. Generally, accumulated profits can reflect transactions arising in the ordinary course of business between non-arm's length parties. The impact on accumulated profits of other non-arm's length transactions must be examined on the basis of the particular facts involved."

Although the question at hand relates to Aco, the transferee in the Transactions, it is necessary to consider the Transactions' consequences to the transferors, Amalco and Parentco. Note that for the remainder of this document, reference to Parentco will be a reference to Parentco and its wholly-owned subsidiary Amalco, as applicable.

I Parentco's Contributed Capital

In our view, the contributed capital of Parentco should include no profits or gains arising from the Transactions, as this amount would in no way represent "funds provided by its shareholders to commence, or otherwise further, the carrying on of business" as described in paragraph 23 of IT-533.

II Parentco's Accumulated Profits

With respect to whether a transferor's gain should be included in its accumulated profits, our general position, as described in 2003-001008, is that:

"... profits or gains resulting from the disposition of property to persons with whom the taxpayer does not deal at arm's length will generally be excluded from retained earnings".

Although there have been specific circumstances in the past for which we have concluded that the accumulated profits of a corporate transferor would include income arising from the taxable disposition of property to a non-arm's length party (for example 2005-015730 and 2003-005008), no such circumstances are present in the current scenario and, therefore, in our view, the accumulated profits of Parentco should include no profits or gains arising from the Transactions.

III Aco's Contributed Capital

As noted in our comments at the Tax Executive's Institute Conference on February 10, 1988, in which we referred to a transferee in a section 85 rollover for which the increase in value of the transferred assets over the original cost was reflected as contributed surplus of the transferee, we have the general view that:

"... the transferee's capital will not include contributed surplus in those situations where the transferor's gain has not been included in accumulated profits."

Therefore, given our view that the $XXXXXXXXXX and $XXXXXXXXXX gains from the Transactions should not be included in the accumulated profits of Parentco, in our view, they should not be included in the contributed capital of Aco either, i.e., the shares issued by Aco to Parentco in the Transactions should have a contributed capital of $XXXXXXXXXX and $XXXXXXXXXX , respectively, and not their FMVs of $XXXXXXXXXX and $XXXXXXXXXX .

IV Aco's Accumulated Profits

One of our concerns with related party transactions, and their impact on the calculation of a corporation's accumulated profits, is that they could lead to a double counting of a gain or loss on the property transferred: once as capital (if shares are issued on the transfer and their legal stated capital is not reduced for corporate law purposes), and once as retained earnings (since, for accounting purposes, the acquiring corporation records the asset at its historical amount and would recognize the gain when the asset is ultimately sold, thereby increasing retained earnings).

In our view, when determining whether interest was deductible on money borrowed to pay a dividend to Parentco, under the circumstances, the most reasonable method of achieving the goal of not double counting the gain on the Subco1 and Subco2 shares is to, in conjunction with the views expressed in sections I - III above, ignore (i.e., reverse) the $XXXXXXXXXX decrease in Aco's retained earnings which resulted from the application of the Handbook to the Transactions.

Then, once the Subco1 and Subco2 shares are sold to an outside party, and given that their financial statement cost amount is only $XXXXXXXXXX , the accrued accounting gain of $XXXXXXXXXX will be included in Aco's retained earnings, and its accumulated profits, thereby increasing its capacity to borrow to pay a dividend.

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 Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.

R.A. Albert, CA
For Director
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate