7 July 1991 Income Tax Severed Letter - Interest deductibility in various situations

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.

Interest deductibility in situations involving:

• (1) assumed indebtedness in respect of debt, borrowed money, and an amount payable for property acquired;
• (2) accounts payable in respect of goods and services;
• (3) the winding-up of a Purchaser Co. into Opco and the assumption by Opco of Purchaser Co.'s debt; and
• (4) a subsection 85(1) transfer.

Background

A speaker at the 1990 Canadian Tax Foundation Conference questioned the response (reported in the Access Letter) given in a February 26, 1990 technical opinion letter (#5-9484). The gist of that response was that a debt of B Co. to an arm's length person which is assumed by A Co. in repayment of money previously borrowed by A Co. from B Co. would not constitute borrowed money for purposes of subsection 20(3) and subparagraph 20(1)(c)(i). Thus, interest on the assumed debt would not be deductible by A Co.

Queries have also been raised on the other issues noted above. It was therefore considered appropriate to review RCT's position on interest deductibility with respect to these topics.

Additional Information regarding Issue (3) and Issue (4)

Issue (3) arose in an April 30, 1990 technical opinion letter (#5-9730). The assumed facts which illustrated Issue (3) are set out below.

• (1) Purchaser Co. is incorporated for the purpose of acquiring all the issued and outstanding common shares of Opco in an arm's length acquisition.
• (2) Purchaser Co. borrows, at interest, the funds required to purchase the common shares of Opco.
• (3) Subsequent to the acquisition of the common shares of Opco by Purchaser Co., the shareholders of Purchaser Co. transfer all of their shares of Purchaser Co. to Opco and, as sole consideration for the transfer, receive shares of Opco (this transaction is permitted under the relevant company act).
• (4) Purchaser Co. is then wound up into Opco pursuant to subsection 88(1) of the Act.
• (5) As a result of the winding-up of Purchaser Co. into Opco, Opco will have assumed the debt of Purchaser Co. which was originally incurred by Purchaser Co. to acquire the shares of Opco.

The issue is whether interest on the assumed debt is deductible by Opco.

The facts illustrating Issue (4) are detailed in the following paragraphs.

Holdco has real estate with a cost amount of $4,000, a fair market value of $7,000, and a mortgage on the real property of $5,000. The excess amount of the mortgage may have resulted from additional borrowings used in the business, or because the property was written off for tax purposes faster than the mortgage was repaid, or as a result of additional borrowings incurred for "ineligible" purposes. Holdco now wishes to transfer the building and mortgage to a wholly-owned Subco on a tax-deferred basis. The net rental income from the building (after deducting the mortgage interest) is positive.

In order not to exceed the limits imposed by paragraph 85(1)(b) on the elected amount for the rollover, Holdco gives Subco a promissory note for $1,000, the amount by which the mortgage liability exceeds the cost amount of the building. (This is acceptable in accordance with our response to Question 47, 1984 Revenue Canada Round Table.)

As consideration for the transfer of the property and the promissory note, Subco assumes the mortgage and gives Holdco common shares and redeemable preference shares with a redemption price equal to the amount of the promissory note.

Immediately after the transfer of the assets, Subco redeems its preference shares by transferring the promissory note to Holdco.

The issue is whether interest on the $1,000 portion of the mortgage which related to the promissory note would be deductible, given that the paid-up capital, as paid-up capital, as defined in paragraph 89(1)(c) and calculated in accordance with subsection 85(2.1), of the preferred shares is nil and Subco has no accumulated profits.

Decision

Issue 1

A. Interest on assumed indebtedness would not be deductible where A Co. assumes a debt of B Co., including indebtedness attributable to borrowed money of B Co., in payment of money previously borrowed by A Co. from B Co.

B. Assuming the other requirements of paragraph 20(1)(c) are met, interest on assumed indebtedness would be deductible under subparagraph 20(1)(c)(ii) where:

• (i) A Co. purchases a property from B Co. and either assumes B Co.'s mortgage liability in respect of the property or assumes other indebtedness of B Co. in satisfaction of the purchase price; or
• (ii) A Co. had an amount payable to B Co. for property acquired from B Co. and A Co. assumes other indebtedness of B Co. in satisfaction of its obligation to B Co.

Issue 2

While accounts payable are not borrowed money, and consequently do not entitle the debtor to an interest deduction under subparagraph 20(1)(c)(i), in our view interest on accounts payable for the costs of acquisition of property which is a source of income or is used in a business (e.g. investments, fixed assets or inventory) would generally be deductible under subparagraph 20(1)(c)(ii). On the other hand, interest on accounts payable regarding services (e.g. accounting, legal) would not be deductible under subparagraph 20(1)(c)(ii) where the services do not form part of the cost of the acquisition of such property. Interest on accounts payable for those service costs which are currently deductible expenses would be deductible under section 9. Examples include interest on accounts payable related to the property taxes, bookkeeping services, and janitorial services of a business.

Issue 3

The interest on the debt of Purchaser Co. to purchase the shares of Opco which is assumed by Opco as a result of the winding-up Purchaser Co. into Opco is not deductible.

Issue 4

Subject to the limitations otherwise imposed by paragraph 20(1)(c), the interest on the debt assumed by the transferee is deductible provided that no new debt was incurred as part of the series of transactions.

Rationale

Issue 1

It is important to note the distinction between debt and borrowed money. In M.N.R. v. T.E. McCool Ltd., [[1949] C.T.C. 395] 49 DTC 700 (SCC), Mr. Justice Estey commented:

Terms such as `borrowed capital', `borrowed money', in the tax legislation have been interpreted to mean capital or money borrowed with a relationship of lender and borrower between the parties... It is necessary in determining whether that relationship exists to ascertain the true nature and character of the transaction.

The term "debt" has a broader meaning. In A.C. Simmonds & Sons Limited v. M.N.R., [[1990] 1 C.T.C. 2087] 89 DTC 707 (TCC), Mr. Justice Christie commented:

... a person may be financially indebted to another without the relationship of lender-borrower existing between them. In vol. 26 of Corpus Juris Secundum this is said regarding debt at pp 1 and 2:

From the Latin "debere", meaning to owe, "debitum" meaning something owed. It is a word of large import, having several recognized meanings which vary greatly, according to the subject matter and the language in connection with which the word is used. It is a common-law word of technical meaning but it has no fixed legal meaning and it does not have a fixed or invariable signification. It takes shades of meaning from the occasion of its use, and color from accompanying use, and it is used in different statutes and constitutions in senses varying from a very restricted to a very general one. The word implies the existence of a debtor, legality of the obligation, the existence of a consideration, and execution or performance by the creditor.

In order to meet the requirements of subsection 20(3) and subparagraph 20(1)(c)(i), a taxpayer must have used borrowed money to repay money previously borrowed. This would not encompass a situation where existing debt is assumed in satisfaction of an obligation to repay money previously borrowed.

The response given in the February 26, 1990 technical opinion letter would not deny an interest deduction in a situation where A Co. purchases a property from B Co. and assumes B Co.'s mortgage liability in respect of the property. In our view, the interest on the mortgage liability in such a case would be deductible by A Co. under subparagraph 20(1)(c)(ii) (interest on an amount payable for property acquired) and there would be no need to rely upon subsection 20(3).

We also concluded that the response given in the February 26, 1990 technical opinion letter would not have been different had the debt of B Co. which was assumed by A Co. been attributable to a previous borrowing of money by B Co., because an assumption of debt is not a loan of money and does not create a relationship of lender and borrower between the parties. (Blacks Law Dictionary defines a loan of money as "Delivery by one party to and receipt by another party of a sum of money upon agreement, express or implied to repay it with or without interest".)

We note that a new borrowing of money by A Co. from the Bank which is used to repay the money borrowed from B Co. would entitle A Co. to the relief provided by subsection 20(3) and would thus avoid the above noted problems regarding deductibility of interest on assumed indebtedness. Alternatively, as explained below, if B Co. assigned its rights in the A Co. debt attributable to borrowed money to the Bank, A Co. would continue to be entitled to deduct interest under subparagraph 20(1)(c)(i).

As part of our analysis concerning Issue 1, we also considered whether interest deductibility by a debtor under subparagraph 20(1)(c)(i) on indebtedness attributable to borrowed money would be affected should the lender dispose of the indebtedness to a third party. In The Queen v. Pollock Sokoloff Holdings Corp., [[1976] C.T.C. 349] 76 DTC 6181, the Federal Court of Appeal held that the assignee of a debt is not a lender and cannot be said to have loaned money (to the borrower) for the purposes of paragraph 11(1)(e) of the former Act (now paragraph 20(1)(l)).

We note that neither RCT practice nor the courts have employed a "current year test" (unlike the current year "use test") in the interpretation of the reference to borrowed money in paragraph 20(1)(c). Therefore, where a lender assigns his rights in a debt attributable to borrowed money to a third party, and the original debt remains in existence (i.e. where there is no novation of the original debt) the borrower would continue to be entitled to deduct interest under subparagraph 20(1)(c)(i).

Issue 2

The rationale of the decision in Issue 2 is stated in the Decision section. The fact that interest on accounts payable regarding services would not generally be deductible under paragraph 20(1)(c) has been pointed out to the Department of Finance.

Issue 3

The interest would not be deductible by Opco as:

• (1) Opco does not have borrowed money used for the purpose of earning income from a business or property pursuant to subparagraph 20(1)(c)(i), and
• (2) Opco does not have an amount payable for property acquired for the purpose of gaining or producing income therefrom or for the purpose of gaining or producing income from a business pursuant to subparagraph 20(1)(c)(ii). The only property "acquired" by Opco is its own shares and even if the shares are not cancelled after acquisition they are not a source of income to Opco as the relevant company act clearly prohibits a company from paying dividends on the shares held by itself.

IT-315 provides that if all the other requirements of paragraph 20(1)(c) are met, interest on loans incurred by a Canadian corporation to acquire shares of a corporation which is subsequently wound up under subsection 88(1) or amalgamated with the acquiring corporation pursuant to section 87 will continue to be deductible by the Canadian corporation or the amalgamated company provided that the property acquired as a result of the winding-up or amalgamation continues to be used for a qualifying purpose. The position in the bulletin would apply if Opco were wound up into Purchaser Co. provided the property of Opco were used for a qualifying purposes. It would not apply where Purchaser Co. is wound up into Opco because, as noted above, the property acquired, namely shares of Opco, cannot be a source of income.

A copy of the opinion letter in question was forwarded to Finance for use in their interest study.

Issue 4

Issue 4 arose in a ruling request. We provided a favourable ruling. The interest on the mortgage of $5,000 would be deductible under subparagraph 20(1)(c)(ii) notwithstanding our acceptance for purposes of subsection 85(1) of the allocation of the mortgage between the real property and the promissory note, provided no new debt is incurred as part of the series of transactions. We were advised that Finance's tax policy view was that where no new debt is incurred as part of a series of transactions and the interest on the debt was formerly deductible by the transferor, the interest should remain deductible by the transferee, subject to limitations otherwise imposed by paragraph 20(1)(c). [We had previously decided to rule favourably on paragraph 20(1)(c) when the application of subparagraph 85(1)(b) is avoided in a similar manner in butterfly transactions.]

Conclusion

A copy of this decision summary will be forwarded to Finance for consideration in their ongoing interest study.