Interest deductibility pursuant to paragraph 20(1)(c) of the Income Tax Act1 (the "Act") is a dynamic and evolving area of the law, due to CRA Policy and judicial interpretation of the provision. Much of the analysis focuses on identifying the use and purpose of borrowed money, pursuant to subparagraph 20(1)(c)(i) of the Act. In the recent decision of The TDL Group Co. v. The Queen,2 ("TDL Group") the Tax Court of Canada ("TCC") examined what evidence is required to satisfy whether borrowed funds were used for an income earning purpose, and specifically within the context of loans from a parent corporation used to acquire additional common shares in a U.S. wholly-owned subsidiary. CRA Policy (IT-533) normally considers interest costs in respect of funds borrowed to purchase common shares to be deductible; however, this is on the basis that there is a reasonable expectation, at the time the shares are acquired, that the common shareholder will receive dividends.3 CRA Policy, however, qualifies that each situation must be dealt with on the basis of the particular facts involved.4 TDL Group is an instance where the particular facts were unable to meet the above criteria. Exploration of the TCC's evidentiary analysis and application to the legal test follows. It should be noted that this case is under appeal to the Federal Court of Appeal.
Subparagraph 20(1)(c) of the Act provides that:
(1) Deductions permitted in computing income from business or property. Notwithstanding paragraphs 18(1)(a), 18(1)(b) and 18(1)(h), in computing a taxpayer's income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:
(c) Interest – an amount 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
(i) borrowed money used for the purpose of earning income from a business or property (other than borrowed money used to acquire property the income from which would be exempt or to acquire a life insurance policy),
The Supreme Court of Canada ("SCC") in Shell Canada Ltd. v. The Queen,5 ("Shell Canada") held that paragraph 20(1)(c) has four elements:
1) the amount must be paid in the year or be payable in the year in which it is sought to be deducted;
2) the amount must be paid pursuant to a legal obligation to pay interest on borrowed money;
(3) the borrowed money must be used for the purpose of earning non-exempt income from a business or property; and
(4) the amount must be reasonable, as assessed by reference to the first three requirements.
In Singleton v. The Queen,6 ("Singleton") the SCC confirmed that the direct use of the borrowed money must first be ascertained. Specifically, Major J. stated:
Only the third element is at issue in this appeal: the borrowed money must be used for the purpose of earning non-exempt income from a business. The Shell case confirmed that the focus of the inquiry is not on the purpose of the borrowing per se, but is on the taxpayer's purpose in using the money. McLachlin J. agreed with Dickson, C.J. in Bronfman Trust that the inquiry must be centered on the use to which the taxpayer put the borrowed funds.7...
In Ludco Enterprises Ltd. et al. v. The Queen,8 ("Ludco") it was undisputed that the funds were used to purchase shares and therefore the analysis was whether there was an income-earning purpose in acquiring such shares. In Ludco the SCC affirmed it is not necessary that the sole purpose must be to earn non-exempt income and that such purpose may also be an ancillary one.9
The SCC elaborated in Ludco that the appropriate test for interest deductibility under subparagraph 20(1)(c)(i) is as follows:
Having determined that an ancillary purpose to earn income can provide the requisite purpose for interest deductibility, the question still remains as to how courts should go about identifying whether the requisite purpose or earning income is present. What standard should be applied? In the interpretation of the Act, as in other areas of law, where purpose and intention behind actions is to be ascertained, courts should objectively determine the nature of the purpose, guided by both subjective and objective manifestations of purpose: ... In the result, the requisite test to determine the purpose for interest deductibility under s. 20(1)(c)(i) is whether, considering all the circumstances, the taxpayer had reasonable expectation of income at the time the investment was made.10
Reasonable expectation accords with the language of purpose in the section and provides an objective standard, apart from the taxpayer's subjective intention, which by itself is relevant but not conclusive. It also avoids many of the pitfalls of the other tests advanced and furthers the policy objective of the interest deductibility provision aimed at capital accumulation and investment, as discussed in the next section of these reasons.11
Thus, the above legislation and SCC case law confirm the following factors to consider when analyzing whether a taxpayer had a reasonable expectation of income at the time the investment was made, under subparagraph 20(1)(c)(i) of the Act:
1) the borrowed money must be used for the purpose of earning non-exempt income from a business or property;
2) the direct use of the borrowed money must first be ascertained;
3) the sole purpose does not necessarily need to be to earn non-exempt income, an ancillary purpose is sufficient;
4) the test must be applied at the time the investment, or the date shares are acquired; and
5) all the circumstances must be considered.
With the above principles in mind, the facts surrounding the TDL Group case ensue.
The Appellant TDL Group, appealed a reassessment denying interest deductions regarding its 2002 taxation year totaling $10,094,856 on loans from a parent company, Delcan Inc. ("Delcan"), used to acquire additional shares in a wholly-owned U.S. subsidiary, Tim Donut U.S. Limited ("Tim's U.S."). The interest claimed and denied related to interest paid for the period of March 28, 2002 to November 3, 2002. The Minister of National Revenue (the "Minister") disallowed the deduction pursuant subparagraph 20(1)(c)(i) of the Act on the grounds that the funds borrowed were not used for the purpose of earning income from a business or property, and in particular, from the U.S. subsidiary shares acquired to borrow the funds.12
In terms of the tracing the transactions, Wendy's International Inc. ("Wendy's" the taxpayer's ultimate parent company) loaned $234,000,000 Cdn., to its U.S. subsidiary, Delcan, which then loaned it to the Appellant prior to March 18, 2002, with interest pursuant to a loan agreement and assigned this loan receivable to another affiliate in the corporate group. The Appellant then used the loan from Delcan to purchase 1,840 additional common shares in its already wholly-owned U.S. subsidiary, Tim's U.S. on March 26, 2002, which then made an interest free loan to Wendy's the next day, March 27, 2002 supported by a promissory note of the same date. Effectively, monies that originated with Wendy's were loaned with interest, and found their way back to Wendy's, interest free through a series of transactions.13The Appellant led evidence indicating that the promissory note was initially intended to bear interest according to planning memorandums, however, due to concerns that an interest bearing note would have on state taxes in the U.S., and concerns regarding the Thin Capitalization Rules and Foreign Accrual Property Income Rules under the Act, it was decided that the loan would proceed on a non-interest basis, pending a resolution of the matter.14
In June 2012, Tim's U.S. incorporated a new U.S. subsidiary, Buzz Co., which subsequently changed its name to TD U.S. Finance Co. ("Tim's Finance"). Tim's U.S. then assigned the promissory note to Buzz Co. as payment for its shares in Buzz Co. Thereafter, Buzz Co. issued a demand for payment on the promissory note to Wendy's, which repaid the promissory note in full by issuing a new promissory note to Buzz Co. on November 4, 2002 for the same full amount, with interest – in essence, replacing the non-interest bearing loan with a new interest bearing one.15Emphasis should be placed on the fact that the Minister denied the Appellant's interest deduction on its loan from Delcan for the above stated period of March 28, 2002 to November 3, 2002, which aligns with the time that the Appellant's U.S. subsidiary loaned the money back to Wendy's on an interest free basis pursuant to the promissory note.
ISSUES ON APPEAL
The issues raised were whether:
1) the $234,000,000 Cdn. borrowed from Delcan was used by the Appellant for the purpose of earning income from the common shares it acquired in Tim's U.S.; and
2) the amount of interest was reasonable.
The TCC summarized the issues as whether the requisite elements, and specifically elements (3) and (4) as outlined in Shell Canada above, were met.16
ANALYSIS AND CONCLUSIONS
In framing its analysis, the TCC posed the question: "Can it be said that the Appellant had the reasonable expectation to earn income; either immediate or future dividend income or even increased capital gains as a result of the purchase of shares at the time of such purchase?"17The TCC held there was no reasonable expectation to earn income and the sole purpose of the borrowed funds was to facilitate an interest-free loan to Wendy's while creating an interest deduction for the taxpayer. As a result, the appeal was dismissed.
Given the TCC's conclusion, it did not consider arguments regarding whether the interest in question was reasonable.
The TCC focused on the following evidence when arriving at its conclusion:18
1) The Appellant was the sole shareholder of Tim's U.S. prior to and at the time of purchasing the additional shares. As well, there was no history of payment of past dividends, partially due to past losses.
2) The evidence of the Appellant's own witnesses, the former CEO, and the former CFO, confirmed the corporate group policy of no returns on investments or dividends, until all capital expenditures were funded.
3) An examination of the 10-year plan revealed a line item for dividends to be paid and zero dividends were planned, nor were there projections on dividends in the 10-year plan.
4) There was no reference of any potential for dividends to be paid in any of the planning memorandums, or resolutions of the directors of the Appellant, Tim's U.S., or Tim's Finance (Buzz Co.).
5) The fact that the funds used to purchase the new shares were instantly loaned to Wendy's without interest for seven months after which funds were paid back in their entirety indicates no obvious expectation that such funds created or were expected to create any income for Tim's U.S., which in turn, would increase its ability to pay dividends or increase the value of its shares for the future income benefit of the Appellant.
6) The funds loaned to Wendy's on an interest free basis were intended to be short-term and a temporary loan at the time of advance.
7) The absence of credible evidence that any portion of the funds invested in Tim's U.S. were used or intended to be used for any other purpose other than to loan monies to Wendy's on an interest free basis at the time of the investment in Tim's U.S. shares.
Along these lines, the TCC commented that the evidence indicated that all members of the corporate group intended and were aware that the money was returning to Wendy's. The TCC highlighted an absence of evidence speaking to funds being used to pay indebtedness of Tim's U.S. to Wendy's or use of the funds for capital expenditures.
The TCC also rejected the Appellant's argument that capital expenditures were made on behalf of Tim's U.S. in 2002 through intercompany loans, whereby the monies loaned to Wendy's from Tim's U.S. purportedly found their way back. The TCC responded to this argument by concluding that, the demand for repayment for all of the initial amount lent to Wendy's under the promissory note and the actual repayment of the full amount, seven months later, was sufficient evidence for the Court to hold that there were no off-setting amounts claimed against Tim's U.S. as a result of any inter-company loan reconciliation.
The TCC emphasized that any repayments on capital expenditures occurring within the life of the new promissory note, versus the original promissory note, were of no assistance.
The TCC further commented that given there was an eligible direct use of the funds, that being the purchase of common shares, there was no need to explore an exceptional circumstances exception within the context of an ineligible use.
The TCC also rejected the Appellant's argument that it always had the subjective intention to earn income from its purchase of the shares because the group plan had always been for Tim's U.S. to charge interest on its loan to Wendy's. The TCC held that the evidence simply did not support such a contention as the loan proceeded on an interest free basis as demonstrated in the original promissory note.
Although not cited in the TDL Group decision, it appears the TCC is following the evidentiary analysis of Swirsky v. The Queen19("Swirsky") . In Swirsky, the TCC held that Appellant failed to show that his wife had a reasonable expectation of income when she acquired the common shares at issue. In Swirsky, the Court accorded weight to the following factors in its analysis: 1) the company's history of paying dividends prior to the share acquisition, and immediately after the transactions occurred;202) evidence of consideration regarding the income earning potential of the shares prior to the transaction, in the form of discussion, or any policy or plan in place to pay dividends on those shares after acquisition;21and 3) evidence from the wife that at the time she entered into the transactions that there would be dividends on the shares, or evidence that she intended to sell the shares at a profit.22The TCC arrived at its conclusion despite dividends eventually being paid on the shares, however, this was after a substantial amount of time had passed since their purchase.23Interestingly enough, a similar pattern of facts arose in TDL Group as it relates to later paying dividends.24
The findings in TDL Group and Swirsky suggest that when considering interest deductibility, as it relates to common share acquisition, one should consider: 1) the past history of dividend payment; 2) corporate policy and long-term plans of returns on investments and dividends; and 3) the documentation that exists around the date of the share acquisition that would speak to expectation to earn income.
Singleton, Shell Canada and Ludco state that courts must be sensitive to the economic realities of a transaction and to the general object and spirit of the legislative provision, in this case subparagraph 20(1)(c)(i) of the Act. It is appreciated that when a provision is clear and unambiguous, its terms must simply be applied.25It appears, however, that the fact driven nature of ascertaining reasonable expectation to earn income at the time of common share purchase is heavily influenced by objective documentary evidence in the form of corporate plans and dividend history, notwithstanding the subjective element of the test outlined in Ludco. Further consideration of the provision will prove interesting.
1 Income Tax Act, R.S.C. 1985, c.1 (5th Supp.) ["Act"].
2 2015 TCC 60 ["TDL Group"].
3 IT-533, para. 31.
5  3 S.C.R. 622 at para. 28 ["Shell Canada"].
6 2001 SCC 61.
7 Ibid. at para. 26.
8 2001 SCC 62.
9 Ibid. at para. 52.
10 Ibid. at para. 54.
11 Ibid. at para. 55.
12 TDL Group at para. 2.
15 Ibid. at para. 3.
16 Ibid. at para. 13.
17 Ibid. at para. 31.
19 2013 TCC 73; affirmed 2014 FCA 36.
20 Ibid. at paras. 32-36.
21 Ibid. at para. 46.
22 Ibid. at para. 41.
23 Ibid. at para. 47.
24 TDL Group at para. 31.
25 Shell Canada at para. 40.
Originally published in Taxes & Wealth Management, May 2015.
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