2014-0555291I7 Interest deductibility

Principal Issues: Whether interest on a debt assumed to acquire shares is deductible following an amalgamation and subsequent return of capital?

Position: Yes, based on the facts provided.

Reasons: Application of principles established by case law.

Author: Grégoire, Sylvain
Section: 20(1)(c)(ii)

                                                                                    February 5, 2016

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                                                                                    Sylvain Grégoire

                                                                                    2014-055529

Interest deductibility – Purchase of target, amalgamation and capital reduction

We are writing in reply to your correspondence of October 9, 2014, in which you asked whether interest payable on a debt assumed by a Canadian corporation in respect of the acquisition of the shares of another Canadian corporation remains deductible following the amalgamation of those two corporations and the subsequent distribution of certain assets of the resulting company to its shareholder as a return of capital.

All statutory references herein are to the Income Tax Act.

Facts

For illustrative purposes, we will use the following assumed facts:

*     Canco 1 owns 100% of both Canco 2 and Canco 3.
*     Canco 3 has a fair market value of $1,000. Its assets consist of shares of a foreign affiliate (FA) worth $300 and other assets, worth $700, used in its business carried on in Canada.
*     Canco 2 acquires all of the shares of Canco 3 from Canco 1 in exchange for common shares of $600 and the assumption of a debt of Canco 1 in the amount of $400 (the “Assumed Debt”).
*     Canco 2 and Canco 3 amalgamate to form Amalco.
*     Amalco distributes the shares of FA to Canco 1 as a return of capital.

All transactions are assumed to occur in a very short period of time.

Our comments

Subparagraph 20(1)(c)(ii) provides for a deduction in respect of “an amount paid in the year or payable in respect of the year ... pursuant to a legal obligation to pay interest on an amount payable for property acquired for the purpose of gaining or producing income from the property or for the purpose of gaining or producing income from a business ...”. As indicated in paragraph 1.62 of Income Tax Folio S3-F6-C1 Interest Deductibility (the “Folio”), it is the CRA’s position that assumed debt can be considered to be an amount payable for property acquired, as contemplated in subparagraph 20(1)(c)(ii), where, as in this illustrative fact pattern, it is assumed as part of the purchase price of an asset acquired by the taxpayer.

The Income Tax Rulings Directorate has previously considered situations similar to the one presented above, in the context of income trust set-ups, where an internal leveraged buy-out is put in place (see Income Tax Technical News 34, dated April 27, 2006, under “Income Trusts and Interest Deductibility”). In that context, we opined that subparagraph 20(1)(c)(ii) could apply post-amalgamation in a similar fashion to a “borrowed funds” situation described in what is now paragraph 1.44 of the Folio. In other words, 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. This is also consistent with the comments in paragraph 1.63 of the Folio, in respect of substituted property in the context of subparagraph 20(1)(c)(ii).

In our view, the situation you have presented is different in only one significant respect: there is an immediate distribution of a valuable asset of the company following the amalgamation. Thus, a question arises as to how one is to allocate the Assumed Debt to the various assets of Amalco. 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, similar to the reasoning adopted in paragraph 1.65 of the Folio in respect of notes directly issued to pay dividends or to return capital.

However, based on the illustrative facts presented above, and taking into consideration the flexible tracing approach mandated by the Supreme Court of Canada in Ludco Entreprises Ltd. et al. v. The Queen, 2001 DTC 5505 (SCC) as well as the comments in paragraph 1.38 of the Folio, we are of the view that 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.

For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency’s electronic library. A severed copy will also be distributed to the commercial tax publishers, following a 90-day waiting period (unless advised otherwise), 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 the taxpayer request a copy of this memorandum, they may request a severed copy using the Privacy Act criteria, which does not remove taxpayer identity. Requests for this version should be e-mailed to: ITRACCESSG@cra-arc.gc.ca.

We trust that these comments will be of assistance, and thank you for your enquiry.

Dave Beaulne, CPA, CA
Section Manager
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
 

cc. Donna O’Connor, International and Large Business Directorate, CPB

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