Paragraph 20(1)(c) - Interest

CRA ruled on a triangular loss-shifting transaction between Lossco and its subsidiary, Profitco, under which Lossco used a daylight loan to make an interest-bearing loan (pursuant to the “IB Note”) to Profitco, who subscribed for preferred shares of its sister, “Numberco,” who made a non-interest-bearing loan to Lossco. The Numberco preferred shares were to bear a cumulative dividend at a rate 1 b.p. above the rate of simple interest on the IB Note. Recourse under the IB Note was to be limited to the Numberco preferred shares.

The 0.1% general partner interest in some LPs carrying on business is held by a corporation (Eco) at the bottom of a stack of wholly-owning corporations (Aco holds Bco, which holds Cco, which holds Dco, which holds Eco), and the 99.0% limited partner interests in the LPs is held by Dco.

Regarding a bank loan received by Dco whose proceeds are used by it to make an interest-free loan to the LPs, CRA stated:

[T]he comments in … S3-F6-C1, [paras. 1.54, 1.55] could apply in the partnership context … .

[I]f … it is shown that the loans made by Dco to the LPs affect Dco's ability to earn income from the LPs, the interest on Dco's loan from the financial institution may be deductible to Dco pursuant to subparagraph 20(1)(c)(i), if all other conditions are otherwise satisfied.

Regarding the bank loan instead being made to Aco which uses the proceeds to directly or indirectly make an interest-free loan to the LPs (e.g., making such loan to Dco which, in turn, makes interest-free loans to the LPs, or to Bco, with back-to-back interest free loans made all the way down the stack), CRA stated:

[I]n light of … Canadian Helicopters, the fact that the taxpayer's income is derived from dividends from stacked corporations should not be a factor that … prevents a taxpayer from relying on the direct use of borrowed funds exception to make an interest-free loan.

[I]t would be necessary to assess … whether the interest-free loans made by Aco to the LP, Bco or Dco … affect Aco's ability to earn income. If so, the interest on Aco's loan from the financial institution may be deductible to Aco pursuant to subparagraph 20(1)(c)(i) on the basis of the exceptional circumstances principle, if all of the conditions are otherwise satisfied.

Background

Aco, a public corporation, wholly owns Xco and Yco, and all three corporations hold shares of Bco, which holds all the shares of Cco. Both Bco and Cco have accumulated profits and retained earning, and Cco has significant liquidity. Bco recently incorporated Newco, and subscribed for one common share. An interest-bearing loan is owing by Bco to Cco (the "Cco-Bco Loan")

Proposed transactions

1. Bco will transfer to Newco all its common shares of Cco on a s. 85(1) rollover basis in consideration for Newco issuing common shares and a demand non-interest bearing promissory note (the "Bco-Newco Note"), which is convertible after a specified period at the holder’s option into Newco common shares with an FMV equaling that of the note.
2. There will be a short-form amalgamation of Newco and Cco, so that the share capital of Amalco will be identical to that of Newco.
3. Bco will exercise its right to convert the Bco-Newco Note to common shares of Amalco.
4. Amalco will effect a reduction in the share capital account for its shares in cash, with Bco applying such cash to repay the Cco-Bco Loan owing to Amalco.
5. Amalco will borrow from arm’s-length lenders and use the proceeds in the share capital account for its shares held by Bco.

Rulings

Including that:

To the extent that the Borrowings [in 5] will replace capital of Amalco (i.e., of XXXXXXXXXX on the common shares of the capital stock of Amalco) that is being used by Amalco for eligible purposes, and that such capital will continue to be used for eligible purposes for the purposes of subparagraph 20(1)(c)(i), interest paid in the year or payable in respect of the year (depending on the method regularly followed by the taxpayer in computing the taxpayer’s income), pursuant to a legal obligation to pay interest on the borrowed money, will be deductible by Amalco in computing its income for the year pursuant to subparagraph 20(1)(c)(i). However, such interest will be deductible only to the extent that it is reasonable in the circumstances and provided that the deduction is not prohibited by any other specific provision of the Act.

For [such] purposes … the capital of Amalco attributable to the Bco-Newco Note and the XXXXXXXXXX of common shares of the capital stock of Amalco of $XXXXXXXXXX will be considered to be used by Amalco for eligible purposes for the purposes of subparagraph 20(1)(c)(i) provided that the property that will become property of Amalco on the amalgamation of Newco and Cco or the property that will be substituted therefor will be used and will continue to be used by Amalco for the purpose of gaining or producing income from its business.

In the supplementary letter, CRA ruled that the amount of "accumulated profits" of Amalco for purposes of the "filling the hole" concept for the purposes of paragraph 20(1)(c), would be a specified amount at the time of the amalgamation.

Realco will pay a stock dividend consisting of Class F preferred shares, thereby reducing its accumulated profits and safe income attributable to its common shares by the amount of the dividend. Realco will then use the proceeds of a bank loan (as well as of the sale of marketable securities and of cashing in term deposits) to redeem the Class F preferred shares.

Ruling respecting the deductibility under s. 20(1)(c)(i) of the interest on such loan.

CRA provided standard loss-shifting rulings under transactions in which three losscos in the group annually shift losses to a single newly-incorporated Lossco, which is then sold at FMV to a Profitco in the group whose ownership is redacted, with the Lossco immediately wound-up into the Profitco under s. 88(1.1). The interest-bearing loans, whose proceeds were used by the new Lossco to subscribe for preferred shares of Newcos, were made to Lossco on a limited recourse basis, i.e., recourse was limited to such preferred shares.

Proposed transactions

1. ACo, a listed Canadian public company, whose outstanding convertible debentures (the “Debentures”) are about to mature, will borrow from a lender (BCo) under “Loan 3.”
2. It then will issue a redemption notice to redeem all of the outstanding Debentures for their principal amount plus accrued interest.
3. Since the Debentures have a substantial accrued gain based on their conversion price and the market price of ACo’s shares, this will prompt most or all of the holders of the Debentures to exercise their conversion rights.
4. However, upon receiving the notices of redemption for the Debentures, ACo will have the right to redeem such Debentures for an amount corresponding to the market value of the ACo shares into which they are convertible – which it will do, using proceeds of Loan 3 and thereby paying a “Conversion Premium C” over the redeemed Debentures’ principal amount.
5. The Conversion Premium will be less than ACo’s accumulated profits.

Rulings

CRA ruled (TaxInterpretations translation):

To the extent that the portion of Loan 3 (as described in paragraph 25 above of the Proposed Transactions of the Letter [see 1 above]) will be used by ACo in order to pay the Conversion Premium C (as described in paragraph 26 of the Proposed Transactions of the Letter [see 4 above]) in replacement of the capital of ACo (being its “accumulated profits” (as described in paragraphs 1.50 and 1.51 of Income Tax Folio S3-F6-C1, Interest Deductibility) for purposes of the “filing-the-hole” concept used in applying paragraph 20(1)(c)) not exceeding the amount of the Conversion Premium C which is used by ACo for an eligible purpose, and that such capital will continue to be used for eligible purposes for purposes of the application of subparagraph 20(1)(c)(i), the interest paid in the year or payable in the year (depending upon the method regularly followed by the taxpayer in computing its income) by ACo, pursuant to a legal obligation to pay interest on borrowed money (being the portion of Loan 3 which will be used by ACo to pay the Conversion Premium C), will be deductible by ACo in computing its income for the year pursuant to subparagraph 20(1)(c)(i). However, such interest will be deductible only to the extent that it is reasonable in the circumstances and provided that the deduction is not prohibited by virtue of another specific provision of the Act.

Completed transactions

Similar Debenture redemption transactions had already been completed (involving the application of “Loan 1” and “Loan 2”), and CRA provided similar rulings for these.

CRA ruled respecting a transaction for the transfer of non-capital losses from Profitco to its Lossco parent by means of Lossco lending at interest to Profitco, Profitco subscribing for pref of a newly-incorporated sister corp (Newco) and Newco lending without interest to Lossco.

Notwithstanding that the loan made to Profitco was subordinated, the ruling letter states that the interest rate is “based on a comparison to the most recent arm’s length senior secured financing issued” by Lossco.

In a triangular amalgamation, is the interest on a third party loan obtained by ParentCo to redeem preferred shares issued by TargetCo as part of the transaction deductible under s. 20(1)(c)? CRA responded that interest on borrowed money used to redeem shares (preferred shares, in this example) would be deductible under s. 20(1)(c), to the extent that the amount of borrowed money does not exceed the capital of the shares, computed prior to the redemption of such shares, and provided that the capital replaced by the borrowing was previously used for eligible purposes.

The interest amount must also be reasonable in the circumstances, and there must be a legal obligation to pay such interest.

The common shares of XY Inc. (with an active business) are held equally by the two holding companies for X and Y (namely, X Inc. and Y Inc.), and X and Y each holds a preferred share (or, alternatively, a common share) of XY Inc. directly. Would interest on bank loans used by X Inc. and Y Inc. to make equal (or unequal) non-interest bearing loans to XY Inc. be deductible? After referencing the general principle that “interest expense on borrowed money used to make an interest-free loan … may be deductible … where the facts disclose that the money was borrowed for an indirect current use whose purpose was the earning of income from a business or property,” CRA stated:

The CRA generally agrees that this is the case where, firstly, the interest-free loan affects the corporation's capacity to earn income and, furthermore, the interest-free loan is granted to a corporation by its sole shareholder or, if there are several shareholders, each shareholder has granted an interest-free loan to the corporation in proportion to the shareholder’s interest in the corporation.

In other situations, the taxpayer must demonstrate that making an interest-free loan to a corporation affects the taxpayer's income-earning capacity and, therefore, that there is a sufficient link between the interest-free loan and a source of the taxpayer's income. In this regard, the principles followed in … Canadian Helicopters … could be useful.

A public company (ACo) issued unsecured subordinated Notes, whose more unusual terms were that:

• ACo may in its discretion elect by notice in writing to cancel the payment of the interest coupons on a going-forward basis, but recognizing that it thereupon loses its right to pay dividends (or the equivalent such as share repurchases) until it recommences interest payments.
• On the occurrence of a specified event (presumably, some sort of financial difficulty), the Notes will be converted into a number of common shares based on a formula-determined conversion ratio (such that the shares' value could be well below that of the converted principal amount).
• “The Notes have no scheduled maturity or redemption date. ACo is not required to make any repayment of the Principal Amount except in the event of an event of default.”

The Ruling “Additional Information” states:

The Interest paid or payable by ACo on the Notes will not be deductible under paragraph 20(1)(c) or any other provision of the Act in computing the income of ACo for any taxation year.

CRA went on to rule that the interest amounts paid to an arm’s length Noteholder will not be subject to Part XIII tax under s. 212(1)(b).

Note terms with contingent mandatory conversion event

ACo will issue pursuant to the Trust Indenture subordinated indebtedness (“Notes”) in one or more public offerings in Canada and elsewhere to arm’s length purchasers. The Notes will bear interest at a fixed annual rate until the Interest Reset Date, after which they will bear interest on a specified basis plus a fixed spread. No interest on the Notes will accrue or be payable after the date of a XXXXXXXXXX Event (a “Mandatory Event”). On the occurrence of a Mandatory Event, the Notes will be converted into preferred shares at a conversion ratio of one preferred share for each Note plus a fractional preferred share in respect of accrued but unpaid interest except that for foreign securities’ law purposes, ACo may instead seek to sell the preferred shares on the foreign holder’s behalf. There is acceleration on default, and a specified maturity date.

Rulings

Re s. 20(1)(c)(i) deduction and interest not being “participating debt interest.”

The CRA summary states:

The borrower-lender relationship will continue to exist until such time as a [mandatory conversion event] occurs or until such time as it is or it became apparent the [mandatory conversion event] would occur.

CRA was asked whether a negative interest rate borne on a deposit with a financial institution would be deductible by the depositor. It was assumed that in each year there would always be some months in which the deposit bore positive interest.

CRA responded that the negative interest was not a contra item to the interest income generated in the year, but that such negative return would likely be deductible under s. 9 given that there was a reasonable expectation of earning interest income on the deposit in the year. CRA stated:

The negative return to the client would ... not represent compensation for the use of money and would not constitute interest (or negative interest) to the client. Accordingly, it is our view that the positive interest on the Deposits would not be offset or reduced by the negative returns.

The Taxpayer, which for a number of years had gone without paying interest on its Notes, mostly had not deducted the amounts of the accrued but unpaid interest (which remained unpaid). However, in its return for the year preceding that of implementation of a Plan of Compromise, the Taxpayer added such amounts to its non-capital losses at the beginning of the year.

CRA indicated, in light of the requirement in s. 20(1)(c)(i) that only interest paid or payable in respect of the year may be deducted in that 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 Taxpayer could not deduct the total unclaimed interest expense in the described year, it could request adjustments in respect of the unclaimed interest deductions for the preceding years, as there were non-capital losses in those years that were utilized in the year of the compromise.

A Canadian Acquisitionco acquired Canadian Targetco for a cash base price plus earnout obligations, and then immediately merged with Targetco under a short-form amalgamation. The Rulings Directorate rejected Amalco’s treatment of the earnout payments subsequently made by it as eligible capital expenditures. In the course of addressing its submission that, by analogy to CRA’s position that interest on a borrowing to acquire shares of a target continued to have the original purpose following the disappearance of the target shares on amalgamation and the direct holding of the underlying income-producing assets, the earn-out payments also had an income-producing purpose stated:

[A]lthough we indicated at the 2002 Annual Conference of the Canadian Tax Foundation that our position regarding the deductibility of interest in the context of a leveraged buy-out followed by an amalgamation was supported by the flexible approach of linking adopted... Ludco…there is no “tracing” of the assets of the amalgamated corporation as a replacement or substitution for the shares of the target corporation that no longer exist following the amalgamation. While it might be argued that the amalgamated corporation “acquires” the assets of the predecessor corporations upon the amalgamation, the assets are not legally replacing the shares of the predecessor corporations. Notwithstanding this technical difficulty, from a policy standpoint, it was the CRA’s view that interest should be deductible in the context of a leveraged buy-out followed by an amalgamation. Our position is supported by the general scheme of section 87 which is to treat the amalgamated corporation as a continuation of the predecessor corporations standing in their place with respect to assets, liabilities and tax accounts. Of particular relevance is the rule in subparagraph 87(2)(c)(ii), which provides that the amalgamated corporation may deduct in computing its income for a taxation year any amount paid or payable by it in that year that would, if it had been paid or payable by the predecessor corporation in its last taxation year, have been deductible in computing the income of the predecessor corporation for that year.

(a) Could CRA confirm its position in IT-533, para. 31 notwithstanding certain comments in Swirsky? (b) Does CRA recognize that numerous years may pass before a corporation pays dividends, for example, a mineral or petroleum corporation at the exploration phase, without compromising interest deductibility on a loan incurred to acquire common shares? CRA responded (TaxInterpretations translation):

(a) The comments of the Tax Court of Canada in the Swirsky case respecting the absence of a history of payment of dividends have not effected a modification to our position in paragraph 31 of Interpretation Bulletin IT-533 respecting the deductibility of interest on a money borrowed for the purpose of acquiring common shares. Thus, where a taxpayer incurs a loan in order to acquire such shares on which no dividends have been paid, the interest respecting the loan will be deductible if we consider that at such moment there is a reasonable expectation of eventually receiving dividends on such shares. ...

(b) By itself, the fact that a corporation utilizes its entire liquidity for the purposes of carrying on its business for a certain period does not generally have the effect of limiting the potential for one of its shareholders to claim a deduction by virtue of subparagraph 20(1)(c)(i)...in respect of money borrowed for the purpose of acquiring its shares. However, we would conclude that there is not a reasonable expectation of receiving dividends when the facts and documents indicate clearly that the permanent policy ["politique permanente"] of the corporation is to not pay dividends on the shares in question.

A building was acquired as a rental property and financed with the proceeds of a mortgage on it and a personal residence, and then subsequently it commenced to be used as the home of the taxpayer and spouse. In the context of a general discussion of interest deductibility, CRA stated:

[I]f money is borrowed and used to earn income, such as income from a rental property, the interest is generally deductible. The same applies if the security for the loan is a mortgage on a residence and/or a rental property. If … the use of the property changed and it was subsequently used for personal purposes … this would constitute a change of use and the interest on the mortgages would cease to be deductible … .

A cash pooling agreement (the “first contract”) stipulates that no interest is payable to a financial institution when the combined bank balance of all three corporations in the group (Corporations A, B and C) is positive. The "second contract" between Corporations A and B provides that where no interest has been charged by the financial institution to Corporation B, respecting its use of its line of credit, because of this cash pooling arrangement, then Corporation B is required to pay to Corporation A the equivalent of the interest that would otherwise have been paid by it to the financial institution but for the first contract. A similar contract (also, the "second contract") exists between Corporation A and Corporation C. Are the second contract amounts paid by Corporation B or C deductible under s. 20(1)(c)? CRA responded:

[I]t does not appear that amounts paid by Corporation B and /or Corporation C to Corporation A would constitute interest. …

… [I]t cannot be considered … that the amounts payable by Corporation B and/or Corporation C under the second contract could represent consideration for the use of an amount of capital (or a right to the amount of capital). …

[In addition t]he contractual relationship between Corporation A and Corporation B, on the one hand, and Corporation A and Corporation C, on the other hand, … does not appear to us to create a lender-borrower relationship between those corporations, so that subparagraph 20(1)(c)(i) cannot be applicable.

A trust which is the sole beneficiary of a second trust (Trust B) is entitled to an interest deduction on money borrowed by it to make an interest-free advance to Trust B, which will use the advanced funds to acquire income-producing assets and be required under its declaration of trust to distribute all its income.

As retained earnings do not include a surplus resulting from a revaluation, an amount added to retained earnings as a result of fair value adjustments under section 1500 of the CICA Handbook (Part II, Private Enterprises) should not be included in accumulated profits.

Is the position on cash damming in IT-533 still valid following the Supreme Court’s Lipson decision? CRA responded:

Following the Lipson case, the CRA is of the view that the position stated in paragraph 16 of Interpretation Bulletin IT-533 remains valid.

A three-unit rental property, whose purchase was financed with a mortgage loan (Loan #1), was used 46% (one of the three units) as the individual’s principal residence – but then on January 1, 2007, the individual purchased a new immovable that became his principal residence (the "residence" with the triplex then being used 100% for rentals. Also on that date, the individual borrowed additional amounts as an addition to Loan #1, with that borrowing used partly for personal use and partly to finance the purchase of the residence. In order to complete the financing of his residence, the taxpayer obtained an additional loan (Loan # 2) secured by a mortgage on his residence.

CRA indicated that the deductible interest on the original loan amount increased to 100% with the change in use. However, the additional borrowing was not used for an eligible use.

In indicating that interest on money borrowed by an Opco to make an interest-free loan to another corporation to fund the acquisition of Opco’s shares would not be deductible, CRA stated:

The interest expense on money borrowed and used to make an interest-free loan is generally not deductible since the loan is used directly to acquire property that cannot generate income. However, where it can be shown that the direct use can nevertheless affect the taxpayer's ability to earn income, the interest could be deductible.

… [T]he circumstances do not allow us to conclude that the interest-free loan granted by the operating corporation allows it to earn income.

Would interest on a loan used by an individual to acquire mutual fund units be deductible?

In the first situation (regarding “Loan #1”), the trust makes monthly cash distributions to the individual constituting partly of a return of invested capital and partly distributions of income, and the individual uses the amounts received as a return of capital to pay the interest on Loan #1 and uses the amounts received as an income distribution for personal purposes.. CRA stated:

[T]he funds received upon repayment of principal would be used in part to pay the interest on the portion of Loan #1 that corresponds to the capital repaid upon the capital distribution (Repayment Portion) and in part to pay the interest on the other portion of Loan #1 that relates to the remaining interest in Trust #1. In our view, the Repayment Portion would not be used to earn income and consequently, the interest on the portion of Loan #1 corresponding to the Repayment Portion would cease to be deductible.

In the second situation, the Trust makes income distributions on a monthly basis by issuing new units to the individual. Once a year, the individual redeems a portion of the units and use the proceeds of disposition to pay interest on the loan. CRA stated:

[T]he individual's source of income would be the individual's total interest in Trust #2, i.e., the units initially acquired and the units received as part of the monthly income distributions from Trust #2. …[T] here would be a partial disposition of the individual's source of income at the time the individual disposes of a portion of the individual’s interest in Trust #2 (through the redemption of units).

A corporation uses proceeds of an arm's length borrowing to pay an amount equaling its retained earnings ("RE") for the purpose of paying a dividend to its shareholders, with such RE having been generated is part from the receipt, immediately before the borrowing, from a subsidiary. Is the interest deductible?

Before indicating that it had insufficient information to answer, the Directorate stated:

For this purpose, it is our view that a particular corporation's accumulated profits generally represent its RE, calculated on a non-consolidated basis, while investments are recorded at cost and generally reflect transactions that occur in the normal course of business between parties not dealing with each other at arm’s length. We consider that the impact on accumulated earnings of other non-arm's length transactions must be considered in light of the facts of each particular situation.

Paragraph (c) of the definition of "amount" in subsection 248(1) provides that the amount of any stock dividend is the amount by which the paid-up capital of the corporation that paid the dividend is increased by reason of the payment of the dividend.

Is a sole proprietor still permitted to use the cash damming technique? After referring to its acceptance of cash damming in IT-533, para. 16, CRA stated:

Once the Supreme Court of Canada has rendered its decision in Lipson, we will review the implications of that case and publicly announce the impact of that decision … . However, our position on the cash damming technique remains valid until our announcement.

First situation

An individual borrowed $100,000 from a financial institution to subscribe for 50 new common shares of Opco, as a result of which he now held 150 common shares with an adjusted cost base and stated capital of $100,100. A few years later, at a time that the FMV of the 150 shares is $400,000, the corporation distributes $100,000 of stated capital, which he uses for personal purposes, while keeping the loan outstanding.

Second situation

The individual originally borrowed $40,000 from a financial institution to fund his contribution to a general partnership (the SENC), of which he is one of the three partners. The FMV of his interest is $160,000. The SENC returns the original contributions of the partners, and the individual uses the $40,000 received for personal purposes while keeping his $40,000 loan outstanding. SENC makes a distribution of the $100,000 capital contribution to each partner. The individual uses this amount for personal purposes and keeps the $40,000 loan from the financial institution

CRA stated:

The jurisprudence indicates that it is the current use of the borrowed money rather than the original use of the borrowed money that determines whether the interest is deductible. For that purpose, there must be a direct link between the borrowed money and the current eligible use.

In the situations described above … a direct link should be made between the borrowed money and the funds received on the return of capital or contribution. Consequently, interest would not continue to be deductible since the amount received as a return of capital or contribution is not used for an eligible purpose.

An individual uses proceeds of $100,000 to subscribe for additional common shares of his wholly-owned small business corporation (having retained earnings in excess of $100,000), so that the FMV of his shares increases from $100,000 to $200,000. The corporation then pays $100,000 to him by way of a reduction in the stated capital of the common shares, which he uses to pay off his personal mortgage. CRA stated:

Interest on borrowed money is deductible under subparagraph 20(1)(c)(i) only if the borrowed money is used to earn income from a business or property. … [I]n the above situation that condition is not satisfied since the amount invested in shares is immediately returned to the shareholder.

Regarding whether interest on money borrowed under a line of credit granted by the taxpayer’s spouse and secured on their residence was deductible, CRA stated:

[W]here a taxpayer is responsible for all obligations under a line of credit contracted with the taxpayer’s spouse, we are of the view that the taxpayer will be able to deduct the interest to the extent that the taxpayer can clearly demonstrate that the borrowed money was used by the taxpayer for the purpose of earning income.

A corporation intended to qualify under s. 149(1)(o.2)(ii) had used borrowed money to fund part of its acquisition of a rental-property portfolio, and then used the proceeds from a sale of a portion of the portfolio to pay a dividend or make a capital distribution to its sole shareholder. CRA stated:

[I]f the balance of the loan is equal to the cost of the retained portion of the real property originally acquired, the requirement of clause 149(1)(o.2)(ii)(C) could be satisfied depending on the circumstances.

Regarding whether a loan used to repay the originally-borrowed money would be an eligible loan for purposes of s. 149(1)(o.2)(ii)(C), CRA stated:

[M]oney borrowed by a corporation to repay an amount payable for the acquisition of real property would be an eligible loan for the purposes of clause 149(1)(o.2)(C) where the real property is held for the purpose of earning income.

Regarding the deductibility of interest on borrowed money used for current business expenses in a cash damming context, CRA stated:

Where the borrowed money is used to pay a current expense that is incurred for the purpose of earning business income and is deductible … the test of a direct connection is satisfied in the year the expense is incurred and in subsequent years.

… [I]nterest on borrowed money used to pay a current expense incurred to earn business income will continue to be deductible as long as the source of income, the business, does not disappear. However, the provisions of section 20.1 could, depending on the case, allow the interest to be deductible after the source of income has disappeared.

… [T[he total value of the assets of the business is not a criterion for determining whether interest on borrowed money used to pay a current expense incurred to earn business income is deductible.

In finding that interest on money borrowed in order to pay interest on an interest-deductible loan was itself deductible, CRA stated:

[I]nterest paid in the year or payable for the year (depending on the method ordinarily used by the taxpayer in computing income) on the second loan will be deductible in computing income from a business or property pursuant to paragraph 20(1)(c) if the interest on the first loan is deductible pursuant to that paragraph from income from that business or property.

The taxpayer uses $200,000 borrowed from a bank to acquire mutual fund units. After they have appreciated to $300,000, $100,000 of units is sold, and the proceeds used to pay off a personal use mortgage. Subsequently, the taxpayer takes out a new loan of $100,000 to use to purchase additional mutual fund units. In distinguishing the “flexible approach” discussed in Ludco (at paras. 74,76), CRA stated:

[T]hese principles are applicable where an original property is replaced by another income-producing property or by more than one property, some of which is income-producing. However, in the situation where property acquired for the purpose of earning income is disposed of in part and the proceeds of disposition are used for personal use, the interest on the borrowed money that was used to acquire the original property will not continue to be deductible on the portion of the loan that was used to acquire the property sold since the current use of that portion of the loan is not a purpose for which interest is deductible.

In the above situation, only two-thirds of the interest on the $200,000 loan would be deductible following the disposition of the mutual fund units.

Would interest accruing at a 6% rate on a bank borrowing used to acquire preferred shares or debentures of a controlled corporation yielding a dividend or interest at a 1% rate be deductible? CRA stated:

[W]here an investment (e.g., interest-bearing instrument or preferred shares) carries a stated interest or dividend rate, the purpose of earning income test will be met "absent a sham or window dressing or similar vitiating circumstances". In our view, the fact that the corporation is controlled by the taxpayer, or that the dividend is cumulative or non-cumulative, or that the debenture is or is not convertible into common shares of the issuer, is not sufficient in itself to conclude that the purpose of earning income test has not been satisfied. In addition, paragraph 31 of IT-533 states that interest will neither be denied in full nor restricted to the amount of income from the investment where the income does not exceed the interest expense.

In the course of a general discussion of a structure that resulted in a loan generating an interest deduction in both the US and Canada, the Directorate stated:

Parliament has not yet passed specific legislation to prevent double-dip interest deductions in Canada and other countries for the same loan. In this situation, Canadian taxpayers use the proceeds of borrowing to earn income from a business or property. In our view, we cannot deny the interest deduction to the Canadian corporations described herein solely on the basis that a U.S. corporation is also entitled to a deduction in computing its U.S. income because of U.S. tax provisions.

What is the measure of capital for s. 20(1)(c) purposes where shares issued as consideration for other shares on a s. 85(1) share-for-share exchange have their paid-up capital reduced from their stated capital of $800,000, to $700,000 pursuant to s. 85(2.1), or where the stated capital of shares is increased by an amount equal to consolidated safe income of the corporation? CRA referred to the statement in IT-533, para. 23 that:

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.

It then stated:

However, there may be situations where the legal or stated capital of shares is not an appropriate measure of capital as in the cases described above.

In the course of a general discussion of interest deductibility on money borrowed from a US bank to acquire shares in a private US corporation, CRA stated:

Where preferred shares are entitled to a dividend, the income-producing purpose test is generally satisfied.

In order to generate an interest deduction, Ms. A borrowed money from a bank to purchase shares from Mr. A (also in the top bracket), who used the proceeds to pay off the loan that had been used to acquire the residence. CCRA noted that it was a question of fact whether her borrowing was for the purpose of earning income from property, that “it is the net loss or income determined under the Act that is … attributed” pursuant to s. 74.1(1), so that “the interest expense paid by Ms. A … will be taken into account in determining the loss or income to be attributed to her spouse … pursuant to subsection 74.1(1),” and that s. 245(1) might be determined to apply.

The spouse (Ms. A) of Mr. A will acquired a rental property using proceeds of borrowed money equaling the property’s fair market value, with Mr. A recognize the resulting capital gain and recapture, and using such proceeds to repay loans he had used to acquire the rental property and the family home. CRA indicated that the interest would be deductible to Ms. A provided the usual tests in s. 20(1)(c) were satisfied.

Regarding a taxpayer who borrows money to acquire common shares of a Quebec Business Investment Company (QBIC), CCRA was informed that section 22 of the Québec Business Investment Companies Regulation indicated that a QBIC cannot receive a dividend during the 24 months following the acquisition of shares that constitute a qualified investment to it, so that it, in turn, could not pay a dividends to its shareholders during that same 24-month period if it had no income during that period. CCRA stated:

Where a corporation's governing documents indicate that no dividends are expected to be paid and that shareholders must sell their shares to realize the gain on the shares, the intent test is unlikely to be satisfied. Where a corporation does not have a formal dividend policy, or has a policy of paying dividends when operations permit, the purpose test is likely to be satisfied. …

[T]he provisions of section 22 of the Regulation will not, in and of themselves, prevent the deduction of interest on money borrowed to acquire common shares of a QBIC if there is otherwise a reasonable expectation, at the time the shares are acquired, that the holder of the common shares will receive dividends.

On January 1 of Year 1, an individual borrowed $150,000 to finance part of the $200,000 purchase price of a rental property generating $6,000 of rental income in that year. At the end of that year, the individual repaid $20,000 of the loan. On July 1 of Year 2, the individual borrowed $76,000 from a financial institution on the security of the rental property, and used the borrowed amount for personal purposes.

After referring to the limited scope of the indirect use test, e.g., where a corporation “uses the proceeds of the loan to repurchase shares or return capital,: in which case “interest will be deductible if the borrowed money replaces capital (contributed capital or accumulated profits) that has been used for purposes that would have qualified for interest deductibility if the capital had been borrowed,” CCRA indicated that the interest on the second loan was non-deductible, stating:

[W]e cannot say that the $76,000 loan repaid any principal. … [T]he direct use of the borrowed money is for personal purposes, which is not an eligible use.

CCRA accepted that, under Ludco, the income-earning test referenced amounts added in computing income rather than net income, and indicated that, for example. a taxpayer could rely on the direct use test by selling shares in order to pay off personal debt, and then borrowing money to acquired replacement shares.

It indicated that cash damming is usually effected as follows:

A corporation opens two accounts in its financial institution. The only deposits to Account A are those arising from borrowed money and all other deposits (arising from transactions, etc., and not related to previously borrowed money) are made to Account B. The corporation ensures that all payments from Account A are for expenses that clearly meet the applicable conditions for interest deductibility. If some of the expenses paid from Account B were paid with borrowed money, the interest on that borrowing would not be deductible. Although some of the corporation's expenses are for purposes not otherwise eligible for interest deductibility, the borrowed money is used for specific eligible purposes and the taxpayer has clearly demonstrated those purposes.

An individual was required to guarantee a loan to a corporation wholly-owned by him and then, three years later, the corporation ceased to carry on business and the individual was required to honour his guarantee, which he did with borrowed money. The Directorate stated:

We will accept that interest on a loan taken to honour a guarantee is deductible under paragraph 20(1)(c) of the Act under the exceptional circumstances principle if the taxpayer can show that the guarantee was given for the purpose of earning income.

This may arise in a situation where a parent corporation guarantees a loan of a wholly-owned corporation (or if there are multiple shareholders, where each of the shareholder guarantees a loan of the corporation in proportion to their shareholding) and the guarantor can reasonably expect to generate income from the transaction such as the potential of having additional dividend income receivable.

After noting that, under the jurisprudence, interest ceased to be deductible when the source of income to, which the borrowing related, disappeared, the Directorate went on to indicate that if the subrogated claim became worthless, the taxpayer could continue to have interest deductibility by virtue of s. 20.1(1)(b)(iv).

Will interest payments on a loan paid by a partnership to a partner be considered a distribution (reducing the ACB of the partner’s interest) or as income to the partner? After indicating that they generally would be treated as the former, the Directorate stated:

[T]here may be special circumstances where such a payment would be considered an expense of the partnership, meaning that the interest would relate to a debt to the partner and not a contribution of capital. Such a determination (debt versus capital contribution) would require a review of the contracts and facts surrounding such a situation.

Interest incurred by two taxpayers on money borrowed to acquire common shares was deductible notwithstanding that no dividends in fact were declared (although there was no formal policy not to declare dividends, and whether dividends should be paid was annually reviewed by the board.)

The taxpayer who held an interest (valued at $300,000) in a partnership (the SENC) whose purchase he had funded in part with a $60,000 loan, withdrew $300,000 form the SENC in order to acquire a personal residence, and the obtained a $300,000 mortgage and reinvested the $300,000 in the SENC. After referring to Singleton, the Directorate stated:

[W]hen the taxpayer withdrew all of his capital in the SENC, the interest on the $60,000 loan ceased to be deductible since his withdrawn capital was used to acquire a personal residence which is a non-eligible use so that the borrowed funds were no longer used to earn income from the SENC. Consequently, we are of the view that only the interest on the $300,000 mortgage loan used to replenish the capital in the SENC was deductible.

After referring to the “more flexible” approach to tracing followed in Ludco, CCRA further stated:

[W]here the funds in an account, including borrowed money, are commingled so that tracing/linking is not possible, taxpayers can choose the uses of the borrowed money from all the uses of the money in the account. … [A] taxpayer cannot use this method to meet the traceability/linkage test if tracing can be done.

Before going on to discuss s. 20.1 regarding when a taxpayer no longer has a source of income related to a borrowing, CCRA stated:

As a result of the Ludco decision, we are now of the view that interest on money borrowed to acquire an investment with a fixed rate of income, subject to income tax, will generally be deductible. Thus, where a taxpayer borrows an amount at a rate of, say, 10% and uses that amount to make a loan at a rate of, say, 9%, it is our view that the interest on the borrowed amount will be deductible by the taxpayer if the income derived from the loan is subject to income tax and the expense is reasonable in the circumstances.

After surveying the jurisprudence on the exceptional circumstances test, the Directorate stated:

Interest deductibility in other situations involving interest-free loans by a person to a corporation of which the person is not a shareholder may be justified on the particular facts of the case, as in Canadian Helicopters … and … Byram … to the extent that the person can show that there is a sufficient connection between the interest-free loan and an indirect source of the person's income. However, the fact that the loan was made to protect the income of a wholly-owned corporation of that person where that corporation derives income from the debtor corporation is not sufficient to allow a deduction for interest.

A corporation issued a second debenture pursuant to the terms of an existing debenture, which permitted it to do so in satisfaction of interest on the existing debenture. In finding that interest on the second debenture was not deductible, the Directorate stated:

[T]he interest computed on this amount of Debenture 2 will not be deductible under the provisions of subparagraph 20(1)(c)(i) since there is no lender-borrower relationship between the Corporation and the Creditor in this transaction. Furthermore, it should be concluded that the conditions set out in subparagraph 20(1)(c)(ii) were not satisfied when the debenture was issued, since it was an amount payable but not for the acquisition of property.

A non-resident partner is permitted to deduct interest expense on money borrowed to acquire an interest in a partnership that earns rental income from a property located in Canada if the partner has made an election under s. 216. CRA stated:

Although the partnership interest per se does not generate income, the partnership interest allows the partner to earn income from real property of the partnership.

Paul Lynch and Roy Shultis, "Interest Deductibility: Where From, Where To, Where Now?", 2002 Conference Report, c. 11.

An employee of a CCPC was lent money by the corporation to acquire common shares of the corporation. In finding that accrued but unpaid simple interest on the loan that was capitalized was currently deductible (but not compound interest, which would not be deductible until paid) on the assumption that there was a reasonable expectation of receiving dividends on the shares, the Directorate stated:

Following ... Plawiuk ... the Agency's position is to allow an individual to deduct, pursuant to the provisions of paragraph 20(1)(c), interest accrued and payable, to the extent that the individual regularly uses the accrual method to deduct expenses in computing income from property in respect of shares and that this is the method required under generally accepted accounting principles.

The taxpayer borrowed money from a bank in order to make interest-free advances to its wholly-owned non-resident subsidiary, which subsequently became insolvent. The Directorate stated:

[T[he taxpayer could deduct the interest owed to the Bank if it can demonstrate that, at the time it made the advance to the subsidiary, it had an expectation of income from the shares. If it can so demonstrate, the interest will be deductible pursuant to paragraph 20(1)(c). In addition, the provisions of subsection 20.1(1) may be applicable if there is a disposition of the shares.

Regarding the deductibility of interest on money borrowed to acquire common or preferred shares, the Directorate stated:

[I]n general and unless there are exceptional circumstances, interest on money borrowed to acquire common shares is deductible, taking into account that the potential return to the shareholder may exceed the cost of borrowing. …

[I]nterest on money borrowed and used to acquire common shares may not be deductible where there is no expectation of profit from the investment. For example, in a situation where a corporation has not paid a dividend since incorporation and the facts clearly indicate that it has no intention of doing so, there may be a good argument for concluding that there is no expectation of profit … .

[I]nterest paid or payable on a loan used to acquire preferred shares is fully deductible if the cost of borrowing is equal to or less than the rate of return offered by the preferred shares ... .

However, where the dividend rate is lower than the cost of borrowing, the Agency allows the interest paid on money borrowed to acquire these shares to be deductible to the extent of the dividends included in the borrower's income from the shares in the year, grossed up in the case of an individual … .

CCRA was studying the impact of Ludco and Singleton on various issues including the deductibility of interest on money borrowed to pay dividends or redeem shares, to acquire the shares of a corporation that is amalgamated with the acquiring corporation, to make a loan at less than a reasonable rate of interest or to honour a guarantee for inadequate consideration, to acquire common or preferred shares or to make interest-free loans to employees.

Regarding the deductibility of interest on a mortgage loan that is administratively split in two to allow the taxpayer to repay more quickly the portion of the principal used for personal purposes, CCRA stated:

[T]he simple fact of splitting a mortgage loan in two for administrative purposes does not allow partial repayments of the principal to be considered as first reducing the portion of the principal used for ineligible purposes. Consequently, partial repayments of principal will reduce both the eligible and ineligible portions of the loan.

CCRA indicated that a taxpayer who borrowed money at a higher rate of interest on the bond or preferred shares acquired therewith would be able to deduct the interest to the extent of the preferred share dividends, but would not be able to deduct the interest at all in the case of the bond acquisition.

In Year 1 an individual used $50,000 of borrowed money to acquire 25,000 mutual fund units and the used reinvested income to acquire an additional 2,000 units. In Year 2, he sold 2,500 of the units for $7,500 and used the proceeds for personal purposes. Regarding the portion of the loan that ceased to be used for eligible purposes, the Directorate stated that “due to the fungible nature of mutual fund units, the Agency generally recommends the proration method.” Accordingly, 25,000/27,000 of the 2,500 sold units (or 2315) were treated as a sale out of the loan-financed units. That left 90.74% (22,685/25,000) of the original source of income, so that 90.74% of the loan continued to generate deductible interest.

Summary of policy (based on IT-80) re deductibility of interest on money borrowed in order to redeem shares, return paid-up capital or distribute accumulated profits.

Interest accrued on a loan on a weekly basis, but annual interest payments were only made up to a maximum of 50% of the corporation's after-tax profits, with the balance payable on maturity. CCRA indicated that this payment deferral did not preclude deductibility, stating:

Where only the timing of interest payments is dependent on the corporation's profits rather than the amount of interest on the loan, the loan will not be considered to be a participating loan.

Regarding the deductibility of interest expense on a loan to purchase mutual fund units that gives rise only to capital gains on disposition, the Directorate indicated that “in general and barring exceptional circumstances, interest on money borrowed to acquire common shares is deductible, taking into account that the potential return to the shareholder may exceed the cost of borrowing,” but that there must be a source of income (not including capital gains) and that “interest on money borrowed and used to acquire common shares or mutual fund units may not be deductible where there is no expectation of profit from the investment.”

The taxpayer, who had contracted with a construction firm for the firm to enlarge the taxpayer’s building, failed to pay invoices of the firm based on alleged deficiencies in the work, and then was ordered under a judgment in the resulting action to pay the balance of the unpaid invoices to the firm plus the interest accrued thereon.

The Directorate stated:

With respect to the interest accrued on unpaid invoices that the taxpayer must pay to the Firm, we are of the view that it could be deductible under subparagraph 20(1)(c)(ii) since it is an amount payable for property acquired for the purpose of gaining or producing income, provided that the other conditions of paragraph 20(1)(c) are satisfied. However, if part of the interest expense is attributable to the period of construction, renovation or alteration of the building, the interest expense would instead be capitalized to the capital cost of the building pursuant to subsection 18(3.1).

Regarding a query as to whether a lease under a leasing agreement (“contrat de crédit-bail”) for a truck tractor with a term of 48 months and a bargain purchase option at maturity could be treated as an acquisition by the lessee (“Aco”) of depreciable property under a secured interest-bearing loan from the lessor (a lease financing company), CRA stated:

In the civil law of the province of Quebec, a distinction is made between lease contract ["contrat de location"] and a leasing contract [“contrat de crédit-bail”]. By virtue of the Civil Code of Québec and according to the doctrine, a leasing contract is a named type of contract distinct from a lease contract, and is therefore not a specific type of lease. For the purposes of the Act, the CRA nevertheless considers that the consideration paid by the lessee may be considered in part or in whole as rent to the extent that the leasing contract makes the leased property available to the lessee for its use without transferring ownership of the property. …

Although a leasing agreement is often referred to as a financing agreement, the CRA believes that the leasing agreement cannot be considered a true loan.

The consideration paid by Aco is an expense incurred to have the use of tangible property for the term of the agreement and to acquire a purchase option on that property at the end of that term.

Opco wishes to distribute its accumulated profits of $500,000 to its parent (Holdco) without using cash and so as to generate an interest deduction. It:

• Declares and satisfies a $500,000 dividend through the issuance of preferred shares that have a redemption amount and paid-up capital of $500,000.
• It then immediately redeems the preferred shares through its issuance to Holdco of a $500,000 interest –bearing note.

Before concluding that the interest was deductible under s. 20(1)(c)(ii), CRA referenced its position in Folio S3-F6-C1, para. 1.65 that “where a note is issued to purchase and cancel (or otherwise redeem) shares, interest expense may be deductible under subparagraph 20(1)(c)(ii),” and then stated:

In a situation as such described above where there is a capitalization of a portion of a corporation's accumulated profits as stated capital of the preferred shares of the capital stock of the corporation, the CRA is of the view that the "capital" attributable to the preferred shares for the purpose of applying the "fill the hole" concept … generally corresponds to the paid-up capital of the shares. The purpose test in subparagraph 20(1)(c) (ii) would generally be met since the Note replaces the capital that was used by Opco for eligible purposes.

Consequently, the interest on the Note could be deductible in computing Opco's income if all the conditions necessary for the application of paragraph 20(1)(c) are satisfied.

CRA ruled that the s. 107(2) rollover applied to the distribution by a non-resident trust, to which s. 94(8.2) (or s. 75(2)) no longer applied because its settlor had been dissolved, of Canadian rental property to its sole beneficiary, which was a (presumably non-resident) corporation related to the Canadian-resident lessee of the property. CRA also ruled that mortgage debt, and unsecured debt owing to a group “Finco,” that was assumed on the distribution, qualified as an amount payable for the property by the beneficiary for purposes of s. 20(1)(c)(ii).

Canco repurchased common shares held by a non-resident. Has the affirmation in S3-F6-C1, para. 1.65 of Penn Ventilator been changed by A.P. Toldo? In affirming the Folio position, CRA stated:

The Court in A.P. Toldo suggested that the decision in Penn Ventilator should be applied narrowly. However, it is our view that those comments were obiter and somewhat ambiguous. Accordingly, A.P. Toldo has not caused us to change our position.

Canco 2 acquires all of the shares of Canco 3 from its parent, Canco 1, in exchange for common shares of $600 and the assumption of $400 of Canco 1 debt (the “Assumed Debt”). Canco 3’s assets are the shares of FA worth $300, and Canadian business assets worth $700. Canco 2 and Canco 3 immediately amalgamate, and Amalco immediately distributes its FA shares to Canco 1 as a return of capital. Does the interest on the Assumed Debt remain deductible?

After noting that “assumed debt can be considered to be an amount payable for property acquired,” and that “one can look to the assets of Canco 3 that become assets of Amalco in order to satisfy the purpose test under subparagraph 20(1)(c)(ii) in respect of the Assumed Debt,” the Directorate stated:

If any part of the Assumed Debt is allocable to the FA shares then, after the FA shares are distributed as a return of capital, we would likely take the position that a portion of the interest is not deductible on the basis that there would be no property substituted for the FA shares… .

However, …taking into consideration the flexible tracing approach mandated… in Ludco…as well as the comments in paragraph 1.38 of the Folio…Amalco would be entitled to allocate the entire amount of the Assumed Debt to its assets other than the FA shares. Thus, the interest payable by Amalco on the Assumed Debt would be deductible under subparagraph 20(1)(c)(ii) after the distribution of the FA shares to the extent that the remaining assets are capable of producing income from property or from a business.

Current structure

Sub1 and Sub2 (both taxable Canadian corporations and wholly-owned subsidiaries of Parent) are currently the sole partners of a general partnership (“Partnership”). Partnership carried on an active business. Sub1 was indebted to Partnership under the demand non-interest bearing “Sub1-Partnership Note”), and Parent was indebted to Partnership under the “Parent-Partnership Note,” which was interest bearing and payable on demand.

Proposed transactions

1. Sub1 will repay the Sub1-Partnership Note by assuming Partnership’s accounts payable.
2. Sub1 will assume all indebtedness of Partnership, including the Partnership-Parent Note and Partnership’s obligation to pay “Employee Accruals” under various compensation and retirement plans in consideration for additional Partnership Units.
3. Sub2 will transfer its interest in Partnership to Sub1 in consideration for Sub1 Preferred Shares and a non-interest bearing promissory note (the “Sub1 Note”), jointly electing under s. 85(1). As a consequence Partnership will cease to exist, Sub1 will become the sole owner of all the Partnership property and Sub1 will become subject to all the remaining obligations of Partnership, and immediately after the time that Partnership ceased to exist, Sub1 will carry on alone the business that was the business of Partnership.

Ruling

Interest paid or payable by Sub1 in respect of any debt obligation of Partnership, including the Partnership-Parent Note, assumed by Sub1 as a consequence of the dissolution of Partnership will be deductible by Sub1 under paragraph 20(1)(c) to the same extent that such interest would have been deductible by Partnership if Partnership did not dissolve provided that Sub1 uses the property acquired from Partnership for the purpose of earning income from a business or property (other than income which is exempt or property that is a life insurance property).

Situation 1

In Situation 1, a trust borrows money under a hypothec to acquire a rental property. The trust distributes the rental property to one of its beneficiaries (A), who assumes the hypothec loan (a charge on the property) and thereafter holds the property for the generation of rent.

Situation 2

In Situation 2, an individual (B) borrows money to acquire a rental property. After death, the rental property is devised to B's child (Child). "The legacy ["legs"] is charged with the hypothec and, consequently, Child assumes the balance owing of the hypothec loan," with the property thereafter used by Child for rental purposes. In both Situations, is the interest deductible under s. 20(1)(c)(ii) following the distribution?

CRA stated (TaxInterpretations translation):

Situation 1

. To the extent that the assumption by A of the hypothec loan charging the property is a condition of the distribution…the balance owing under the hypothec loan constitutes "an amount payable a property acquired" for the purpose of ITA subparagraph 20(1)(c)(ii). …

Situation 2

Similarly, the CRA considers that the balance owing under the hypothec loan assumed by Child in the circumstances constitutes "an amount payable a property acquired"… .

Two spouses are the equal owners their residence, and each is subject to 50% of the mortgage. Madame sells some of her shares of her corporation, having a fair market value equaling 50% of the mortgage, to Monsieur in consideration for Monsieur assuming the 50% of the mortgage to which Madame had been subject. Assuming that the sale of Madame's shares to Monsieur is not subject to the s. 73(1) rollover, would Monsieur’s assumption of the portion of the mortgage previously borne by Madame satisfy the test in s. 20(1)(c)(ii)? CRA responded:

In order to answer the question, it must be established whether Monsieur, in assuming a portion of Madame's mortgage loan as consideration for the acquisition of the shares, incurred a new debt for which he was not previously liable and whether he had a legal obligation to pay interest that he was not previously legally required to pay. To this end, it is necessary to determine what the respective legal obligations of both spouses were before the transfer of the shares and what their respective legal obligations were after the transfer of the shares.

Whether a taxpayer has a legal obligation to pay interest on an amount payable for property acquired is a question of mixed fact and law that can only be resolved after a review of all the contracts involved.

After a portion of the restaurant business of corporation (Corporation A) was spun off to a second corporation (Newco) in reliance on the s. 55(3)(a) exception and with the use of special voting-control shares in favour of the patriarch (A), with the two children of A (X and Y) then using interest-bearing loans to purchase most of the shares (being, in part, preferred shares) of Corporation A or Newco. Each child transferred such shares to a new holding company (Holdco X or Holdco Y) in consideration for preferred shares of such holding company and the assumption by it of the interest-bearing loans, with each such holding company then potentially amalgamating with Corporation A or Newco, as the case may be.

CRA indicated that the interest on such assumed debt would not be deductible to Holdco X or Holdco Y to the extent that the acquired shares were non-dividend-bearing preferred shares rather than common shares, and then went on to state:

[A]fter the amalgamation, we consider the debt to have been assumed for the acquisition of the assets from the predecessor companies Corporation A or Newco, as the case may be, in lieu of the acquisition of the shares. If the assets from the predecessor companies Corporation A or Newco, as the case may be, were acquired for the purpose of gaining or producing income from an income or business and all other conditions required for interest deductibility were satisfied, interest on the assumed debt would be deductible to the new corporations resulting from the amalgamations.

A small business corporation with nominal accumulated profits purchased for cancellation shares in its capital having nominal capital in consideration for the issuance by it of interest-bearing debt. After indicating that the indirect use test also extended to s. 20(1)(c)(ii), so that interest on the debt would be deductible to the extent of the capital of the repurchased shares, and the accumulated profits, that had been used in the corporation’s business, CRA stated:

Where only a portion of the debt obligation replaces eligible capital, as would be the case in the Particular Situation, it is our view that the amount that may be deducted as interest expense on the debt obligation is limited to the interest expense relating to that portion of the debt obligation.

In confirming that interest on notes issued to pay dividends was non-deductible, as was interest on loans received from the shareholders to pay off the notes, the Directorate stated:

[I]t is the legal relationship between the parties that must be considered. In that regard, we understand that the notes were issued upon payment of the dividends. In our view, the interest-bearing debt was not used to pay the dividends.

… [T]here is no jurisprudence dealing with filling the hole in a situation such as the one under review. Since the concept of filling the hole is an exceptional circumstance for the purpose of allowing interest deductions, we cannot apply it in this case.

According to the TSO, the taxpayer paid a dividend by issuing interest-free notes, and then refinanced those notes with interest-bearing notes. Headquarters considered that the interest on the replacement notes was not deductible because it did not replace borrowed money nor were they used to acquire property.

After Acquisitionco acquires Target, Acquisitionco transfers all the shares of Target to a newly incorporated sub ("Newco") in consideration for common shares and a promissory note of Newco. Newco and Target amalgamate. To the extent the amount of interest on the promissory note owing by the amalgamated corporation is reasonable in the circumstances, Amalco will be entitled to an interest deduction pursuant to s. 20(1)(c)(ii).