2016-0638241I7 interest deductibility

Principal Issues: Whether the A.P. Toldo decision has caused Rulings to narrow its view of the application of the Penn Ventilator decision.

Position: No.

Reasons: Insufficient basis for a change of position.

Author: Friedlander, Lara G.
Section: 20(1)(c)(i), 20(1)(c)(ii)

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Deductibility of Interest on Note Issued Upon Repurchase of Shares

This is in response to your email of March 16, 2016 regarding the deductibility under the Income Tax Act (Canada) (the “Act”) of interest on a note issued upon a repurchase of shares.

We understand from you that common shares of XXXXXXXXXX (“Canco”) were held by a non-resident related party.  Pursuant to a share purchase agreement, Canco agreed to repurchase those shares.  The repurchase price was satisfied with a promissory note (the “Note”) and with a payment to the Receiver General, on behalf of the shareholder, equal to the non-resident withholding tax exigible upon the deemed dividend that arose upon the repurchase.  The Note originally bore interest at a rate of XXXXXXXXXX% per annum. The Note was subsequently amended to provide for an interest rate equal to a rate based on Canadian banker’s acceptances plus XXXXXXXXXX%.

You have asked for our views as to whether the “fill-the-hole” theory would be applicable in determining whether interest on the Note was deductible to Canco.  In particular, you have asked us whether the position in paragraph 1.65 of Folio S3-F6-C1 has changed as a result of the recent case of A.P. Toldo Holding Corp. v. The Queen, [2014] 3 C.T.C. 2093 (T.C.C.).  Paragraph 1.65 states as follows:

Where a note is issued to purchase and cancel (or otherwise redeem) shares, interest expense may be deductible under subparagraph 20(1)(c)(ii) to the extent of the interest on the amount of the note issued. Any deduction must be within the limits described in 1.48 and 1.49. This is consistent with the decision in Penn Ventilator Canada Ltd. v The Queen, [2002] 2 C.T.C. 2636, 2002 D.T.C. 1498 (TCC). Interest on notes issued to pay dividends or to return capital would not qualify since no property is acquired in such a transaction, as required by subparagraph 20(1)(c)(ii).

Our Comments

The “fill-the-hole” concept is described in paragraphs 1.48 and 1.49 of Folio S3-F6-C1, which states as follows:

1.48  Interest expense on borrowed money used to redeem shares or return capital can be an exception to the direct use test. In connection with this use, the purpose test will be met if the borrowed money replaces capital (contributed capital or accumulated profits) that was being used for eligible purposes that would have qualified for interest deductibility had the capital been borrowed money.

1.49 Contributed capital generally refers to funds provided by a corporation's shareholders to commence, or otherwise further, the carrying on of its business. While in most situations the legal or stated capital for corporate law purposes would be the best measurement of contributed capital, other measurements may be more appropriate depending on the circumstances. In situations where some proportion of shares is being replaced with borrowed money, only the capital of those shares, computed on a pro-rata basis, would be considered to be replaced with the borrowed money. A corporation's deficit does not reduce contributed capital for purposes of this exception to the direct use test.

The Court in Penn Ventilator applied the “fill-the-hole” concept to subparagraph 20(1)(c)(ii) of the Act.  At the annual Association de planification fiscale et financière conference in 2002 (XXXXXXXXXX), the following was stated at the Round Table:

The CCRA has decided not to appeal the Tax Court of Canada decision in Penn Ventilator Canada Ltd., 2002 DTC 1498. Consequently, when a promissory note is issued for redemption of shares, the interest on this note is deductible up to the amount of the principal of the redeemed shares and undistributed benefits that were used with a view to deriving income from a business or property.

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.

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 to extend this waiting period), 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 latter version should be e-mailed to: LPRA-PLAR ITR-DDI Access Team-Équipe d'Accès.  In such cases, a copy will be sent to you for delivery to the taxpayer.

We trust that these comments will be of assistance.

G. Moore
for Director
Reorganizations Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

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