The Federal Court of Appeal has allowed The TDL Group Co. (TDL) to deduct interest on borrowed money which was used to acquire common shares of a wholly-owned US subsidiary, reversing the Tax Court decision rendered last year. The Tax Court had denied the deduction of interest, concluding there was no reasonable expectation of TDL earning non-exempt income from the common shares acquired with the borrowed money. This decision reaffirms the generally accepted position that interest on money borrowed to acquire common shares is deductible (provided there is a possibility of earning non-exempt income, such as dividends on the shares).
TDL had borrowed $234 million indirectly from its ultimate US parent (Wendy's) on an interest-bearing basis and used the borrowing to purchase additional common shares in a wholly-owned US subsidiary (Tim's US). Tim's US lent the monies received from TDL's share subscription to Wendy's on an interest-free basis. The series of transactions resulted in the money that was advanced by Wendy's on an interest-bearing basis being returned to Wendy's as a loan on an interest-free basis.
The Court of Appeal found it relevant that the loan to Wendy's was originally intended to be on an interest bearing basis, but concerns arose under various tax rules in the US and Canada. As a result, TDL decided the loan to Wendy's would be advanced on an interest-free basis until these concerns could be addressed. The non-interest bearing loan was replaced with an interest-bearing loan seven months after the original interest-free loan was made to Wendy's.
The interest expense deduction which the CRA denied related to the interest paid by TDL during the seven month period during which the interest-free loan to Wendy's was outstanding. The Minister had disallowed the interest deduction pursuant to subparagraph 20(1)(c)(i) of the Income Tax Act (Canada) (the Tax Act), on the basis that the money borrowed by TDL was not used for the purpose of earning income from a business or property. The CRA had allowed TDL to claim an interest expense deduction for interest it paid after the debt owing by Wendy's became interest bearing.
The Federal Court of Appeal has confirmed that the appropriate time to determine a taxpayer's "purpose" when the borrowed funds are used to subscribe for common shares is "at the time the investment was made." This test was set out by the Supreme Court of Canada in Ludco Enterprises Ltd. v. Canada, 2001 SCC 62.
Since TDL's purpose was to be determined at that one point in time, the Court rejected the Tax Court's interpretation of implicitly importing into subparagraph 20(1)(c)(i) a requirement that TDL have a reasonable expectation of receiving income from the newly acquired Tim's US shares within the first seven months of ownership of those shares, rather than over the entire period of time the Tim's US shares would be owned.
This is a key finding of the Court, as it is a clear rejection of the notion that the purpose for borrowing money is to be determined by reference to a truncated period of time (rather than considering the contemplated period of ownership of the investment at the time the investment was made). As the Court noted, the temporary use of the subscription proceeds by Tim's US. did not detract from TDL's income-earning purpose behind its acquisition of additional shares in Tim's US.
The Court also rejected the conclusion of the Tax Court that the "sole purpose of the borrowed funds was to facilitate an interest free loan to Wendy's while creating an interest deduction for TDL." The Court reasoned that the Tax Court's conclusion was due to the overriding concern of the Tax Court with tax avoidance.
The Court also found that the rate of interest paid by TDL on the borrowed money was reasonable, rejecting the position of the Minister that since during the initial seven month period the interest payable on the borrowed funds was not reasonable in view of the fact that the same amount was immediately lent back to Wendy's interest-free. This conclusion is anchored in the finding of the Court that the temporary use of the subscription proceeds by Tim's US did not detract from TDL's overall income earning purpose behind its acquisition of additional shares in Tim's US.
The Court followed the Supreme Court of Canada decision in Shell Canada Limited v. Canada, [1999] 3 S.C.R. 622, which held that the reasonableness of the amount paid must be assessed by reference to the terms upon which the monies were lent and the purpose for which the borrower used the money.
This decision removes the uncertainty raised by the Tax Court decision and is a welcome return to previously well-settled ground relating to interest deductibility in respect of money borrowed to acquire common shares. It is also authority for the proposition that anti-avoidance concepts should not be imported into non-avoidance provisions of the Tax Act.
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