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.
APR 11 1988
Specialty Rulings Directorate D. Webb 957-2115
Paragraph 20(1)(c)
The deductibility pursuant to paragraph 20(1)(c) of the Act of interest expense incurred on a liability assumed upon a "rollover" or other corporate reorganization has been brought into question following the case of the Queen v. P.B. Bronfman Trust.
The Bronfman case established or confirmed the following principles of interest deductibility:
1. Except for paragraph 20(1)(c), interest would be a non-deductible capital expense.
2. The statutory deduction for interest in paragraph 20(1)(c) strictly limits the circumstances in which interest can be deducted.
3. The deduction is based on a purpose test that looks to the purpose of the use to which the borrowed funds are put, not the motivation for the borrowing.
"The interest deduction provision requires not only a characterization of the use of the borrowed funds, but also a characterization of "purpose". Eligibility for the deduction is contingent on the use of the borrowed funds for the purpose of earning income".
4. It is the current use of funds and not the original use that must be considered.
5. In order to determine whether borrowed funds have been put to an eligible use, it is necessary to trace the use of funds through successive redeployments.
The Department's policy with respect to interest incurred on funds borrowed to pay dividends is set out in IT-80 and was confirmed at the 1987 Corporate Management Tax Conference. However, the Department also indicated (Q 8 p. 10:14) that interest on money borrowed to pay dividends would be deductible only to the extent of "accumulated profits".
"Appraisal surplus and profits resulting from non-arm's length transactions designed to transform appraisal surplus into profits would not form part of accumulated profits."
As a result of the above, we have encountered a number of problems which are best illustrated by the following examples.
Example 1
Holdco has real estate with a low cost amount and a high fair market value. The shareholder of Holdco wishes to withdraw cash out of Holdco by way of dividend but Holdco has no accumulated profits.
Holdco incorporates Subco and transfers the property to Subco, pursuant to section 85. Holdco takes back common shares and redeemable preference shares with a redemption amount equal to the excess of fair market value of the real estate over the cost amount. Subco borrows to redeem its preference shares and Holdco uses the dividend received from Subco to pay a subsequent dividend.
In accordance with our policy, as expressed at the 1987 Corporate Management Tax Conference, the interest on the money borrowed by Subco to pay a dividend would not be deductible as Subco had no "accumulated profits" at the time of the dividend.
Example 2
Holdco has real estate with a low cost amount, a high fair market value, and a mortgage on the real property which exceeds the cost amount of the property. 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 Subco. The net rental income from the building, after deducting the mortgage interest is positive.
In order not to exceed the limits imposed by subsection 85(1) on the rollover, Holdco gives Subco a promissory note for the amount by which the mortgage liability exceeds the cost amount. (see 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 redeemable preference shares with a redemption price equal to the amount by which the fair market value of the property transferred exceeds the amount of the mortgage assumed.
Immediately after the transfer of the assets, Subco redeems its preference shares for a note. Holdco and Subco cancel the notes by set-off.
In our view the following summarizes the essence of these transactions. Subco acquired 2 assets in exchange for the assumption of the debt; real property and a note. When the note is repaid (by set-off) the source of income for which the funds were borrowed (i.e. the note) disappears and the accompanying interest deductibility would also disappear unless the proceeds are used to acquire another income source. (1984 Round Table Q. 18 pp. 798). In this instance, the funds are not used to acquire another source of income but to pay a dividend that exceeds accumulated profits. Therefore, the interest would not be deductible on a portion of the mortgage that was used to acquire the Note.
From the taxpayers' point of view no additional debt has been added to the corporate group and the ultimate benefits of ownership of the property continue to accrue to the same persons. However, interest expense which was previously deductible is now tainted.
Example 3
Assume the same facts as in Example 2 but assume that Holdco is owned by corporate shareholders CoA and CoB.
CoA and CoB wish to separate and pursue separate interests. They use the provisions of paragraph 55(3)(b) to achieve a tax-deferred divisive reorganization. Holdco transfers an undivided 50% interest in the real property to each of CoA and CoB and each transferee assumes 50% of the mortgage on the property. To the extent that the mortgage exceeds the elected amount a note is given by each of CoA and CoB to Holdco to comply with the limits imposed by subsection 85(1). On the cross redemptions the notes disappear and each of CoA and CoB will have a 50% interest in the property and have assumed 50% of the mortgage.
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Example 4
Assume the same facts as in example 2 but in order to take advantage of the paragraph 55(3)(b) butterfly administrative position, as set out in example 3, a fractional share is sold to a friendly stranger at FMV and then assets are butterflied and reorganized to achieve the desired result.
Discussion
The Department's position is clear that the interest deductibility is denied in Example 1.
Following the reasoning used to deny the deduction in Example 1, it is proper to deny the deduction in Example 2 because borrowed funds are used to pay a dividend in excess of accumulated profits.
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ORIGINAL SIGNED BY Director General Specialty Rulings Directorate Legislative and Intergovernmental Affairs Branch
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