27 June 2003 External T.I. 2003-0017015 - LEVERAGED BUYOUT

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 CCRA.

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

Principal Issues: Whether interest is deductible in leveraged buyout scenario

Position TAKEN:

General comments given on interest deductibility with respect to interest deductibility on money borrowed to purchase common shares, and to redeem shares.

Reasons FOR POSITION TAKEN:

Position released at Canadian Tax Foundation in October 2002

XXXXXXXXXX 2003-001701
G. Moore
June 27, 2003

Dear XXXXXXXXXX:

Re: Paragraph 20(1)(c) of the Income Tax Act (the "Act")

This is in reply to your e-mail of May 7, 2003, concerning interest deductibility.

You have asked for our views solely with respect to interest deductibility in the following scenario:

Purchase Co is going to purchase Target Co. The purchase price will be allocated to common shares and a shareholder loan.

The steps for the Target Co. purchase would be as follows:

1. Target Co. will convert the non-interest bearing shareholder loan into Class A preferred shares.

2. Purchase Co. will borrow from a third party lender and purchase the common shares of Target Co.

3. Target Co. will borrow from a third party lender and redeem the preferred shares.

4. Purchase Co. will exchange the common shares of Target Co. for preferred shares. The preferred shares will have a dividend rate sufficient to pay any interest on borrowed funds to purchase common shares.

Our Comments

It appears that the situation you describe concerns a completed or proposed transaction and therefore, we are unable to provide any confirmation of the tax consequences except, with respect to a proposed transaction, in the context of an advance income tax ruling.

Confirmation of the tax consequences respecting a completed transaction must be obtained from the local tax services office. We can offer, however, the following general comments with respect to the interest deductibility issues raised in your letter.

In Step 1, there are no interest deductibility issues.

With respect to Step 2 of the scenario described above, you have asked whether the interest on money borrowed from a third party lender would be deductible under paragraph 20(1)(c) of the Act. In Step 2, the interest costs in respect of funds borrowed to purchase common shares would be deductible if there is a reasonable expectation, at the time the shares are acquired, that the common shareholder will receive dividends. Nonetheless, each situation must be dealt with on the basis of the particular facts involved.

In Step 3 of the scenario, you have asked whether the interest on money borrowed by Target Co. to redeem preferred shares would be deductible. As you know, interest on borrowed money used to redeem shares can be an exception to the direct use test. In connection with this use, the purpose test would be met in Step 3 if the borrowed money replaces contributed capital that was being used for purposes that would have qualified for interest deductibility had the contributed capital been borrowed money.

In Step 4, you have asked if interest on borrowed money used to purchase common shares would continue to be deductible if Purchase Co. exchanges the common shares of Target Co. for preferred shares and the preferred shares have a dividend rate sufficient to pay interest on the borrowed money that was used to purchase the common shares. In this case, if money is borrowed to acquire a source of property income (common shares) and the original source is disposed of and replaced with a new source (preferred shares), the interest on the original loan would be deductible, at least to the extent of the cost of the new source. Interest sought to be deducted under paragraph 20(1)(c) of the Act must relate to a business or property income source. In Step 4 of this scenario, since the common shares would be exchanged for preferred shares and if there was a reasonable expectation of income at the time of acquisition, the interest on the borrowed money that was used to acquire the common shares would likely continue to be deductible to the extent that the borrowing is reflected in the cost of the preferred shares.

On February 18, 2003, as part of the presentation of the Federal budget, the Department of Finance published the following statement concerning the deductibility of interest:

"Recent court decisions have raised uncertainties as to how taxpayers are to treat expenses, in particular interest, in computing income from a business or property for purposes of the Income Tax Act. Most notably, these decisions could lead to inappropriate tax results where a taxpayer derives a tax loss by deducting interest expenses, even if under any objective standard there is no reasonable expectation that the taxpayer would earn any income (as opposed to capital gains), or where the presence or the prospect of revenue (as opposed to income net of expenses) is enough to conclude that an expenditure was incurred "for the purpose of earning income".

Neither of these results is consistent with appropriate tax policy, nor would they have been generally expected under prior law and practice. Therefore legislative amendments to the Income Tax Act will be considered in order to provide continuity in this important area of the law. Before finalizing any proposals, however, the Department of Finance will release them for public consultation, with a general goal of ensuring that they restore continuity with the expected consequences before these recent court decisions."

We trust that these comments will be of assistance.

Yours truly,

Steve Tevlin
for Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch

??