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: Deductibility of interest on money borrowed to pay dividends
Position TAKEN:
Interest on borrowed money used to pay dividends, to the extent the loan exceeds accumulated profits, is not deductible under paragraph 20(1)(c).
Reasons FOR POSITION TAKEN:
April 2, 2003
MONTREAL TSO HEADQUARTERS
Section 443-4-1 Corporate Financing Section
Small and Medium Business Audit Income Tax Rulings
Verification and Enforcement Directorate
G. Moore
Attention: Frank Antonacci (613)957-2747
2003-001008
Deductibility of Interest on Money Borrowed to Pay Dividends
This is in reply to your email of March 26, 2003, wherein you requested our views regarding interest deductibility on money borrowed to pay dividends.
Further to the conversation (Moore/Antonacci) of March 20, 2003, we understand the situation is as follows:
A corporation (OPCO) lent money to a newly created trust. On the same day, the trust lent money at interest to four corporations controlled by OPCO. The four controlled corporations declared and paid dividends to OPCO for the sums equivalent to the loans from OPCO to the trust. The interest-bearing loans are still outstanding. All the transactions took place on XXXXXXXXXX. The four controlled corporations have negative retained earnings after the dividends were paid to OPCO. In your view, the borrowed money was used for the purpose of paying dividends to OPCO. With respect to the retained earnings of the four controlled corporations, the taxpayer's representative claims that there is contributed surplus (which should be added to the negative retained earnings of the respective corporations) that resulted from a non-arm's length rollover of shares of another associated corporation from OPCO to the four controlled corporations. It is your view that a contributed surplus arising from a non-arm's length rollover of property would be excluded from the retained earnings of a transferee corporation.
Paragraph 20(1)(c) of the Act permits the deduction of an amount paid in the year or payable in respect of the 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 Supreme Court has outlined that direct use is the primary test to determine interest deductibility and that indirect uses will not be acceptable, other than in exceptional circumstances. Trans-Prairie Pipelines Ltd. is the leading case with regard to exceptional circumstances and remains valid today. This case addressed the exceptional circumstances of borrowing to redeem shares. The concept of using borrowing money to "fill the hole" of capital withdrawn from the corporation's business is a key element of this concept.
The amount of capital used for an eligible purpose of earning income prior to the replacement of that capital with borrowed money must be determined. Capital includes the contributed capital and accumulated profits of a corporation. Contributed capital is considered to be the funds provided by the owners of a corporation to commence or to further the carrying on of the corporate business. In most corporate situations, the legal or stated capital for corporate law purposes would be the best measurement of capital for this purpose, although other measurements may be more appropriate depending on the circumstances.
Borrowing to pay dividends is an ineligible direct use, but interest deductibility in such situations may be provided under the exceptional circumstances category, consistent with the concept of borrowing to replace capital to "fill the hole" described above. We generally accept this category of exceptional circumstances and generally accept accumulated profits as the appropriate measurement of the hole that may be filled with the borrowed money used to pay a dividend.
A corporation may borrow to pay dividends to the extent of its accumulated profits or retained earnings. Generally, accumulated profits means retained earnings computed on an unconsolidated basis with investments accounted for on a cost basis. However, profits or gains resulting from the disposition of property to persons with whom the taxpayer does not deal at arm's length will generally be excluded. In Chase Manhattan Bank of Canada v. The Queen, 2000 DTC 6018, the Court upheld the position that interest on borrowed money used to pay dividends, to the extent the loan exceeds retained earnings, is not deductible.
We would agree, with respect to the fact that the dividends paid by the four controlled corporations have exceeded their respective retained earnings, with your view that the interest on the interest-bearing loan would be deductible only to the extent of each of the controlled corporation's respective retained earnings. We also confirm the Agency's position that profits or gains resulting from the disposition of property to persons with whom the taxpayer does not deal at arm's length will generally be excluded from retained earnings.
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."
For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Customs and Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the electronic library version, or they may request a copy severed using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Mrs. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.
Steve Tevlin
for Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch
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