Income Trusts and Interest Deductibility
The typical structure for so-called income trusts is to have the trust hold the shares and notes of a corporation that carries on a business. The interest expense incurred by the corporation offsets the business income. Paragraph 29 of Interpretation Bulletin IT-533 states that interest on a note issued to purchase and cancel (or otherwise redeem) shares will, in accordance with the decision in Penn Ventilator Canada Ltd. et al v. The Queen [Footnote 1] be deductible under subparagraph 20(1)(c)(ii) subject to the limits described in paragraph 23 of IT-533. Paragraph 23 deals with borrowed money used to pay dividends or redeem shares and subparagraph 2 thereof states that borrowed money used to replace the accumulated profits of a corporation that have been retained and used for eligible purposes can be an exception to the direct use test. Therefore, where shareholders desiring to increase their distributions from a corporation had caused a redemption of shares in exchange for shares and debt, the Act and relevant jurisprudence would limit the deductibility of the interest related to the debt to the amount required to “fill the hole” that was formed as a consequence of the return of capital.
Question 1
What is the CRA’s current position on interest deductibility with respect to the “fill the hole” concept when financing the setup of an income trust? More particularly, is interest deductible in full where it is paid or payable on notes issued as consideration for shares of a target corporation acquired by a holding corporation which is part of a restructuring arrangement involving the conversion of the equity position held by shareholders into units of an income trust?
Response 1
Paragraph 21 of IT-533 describes the CRA’s position with respect to leveraged buy-outs and subsequent amalgamations. That paragraph basically states that where shares of another corporation are acquired with borrowed funds and the other corporation is wound-up or amalgamated with the acquiring corporation, the interest will be deductible as a link has been established between the shares that were initially acquired and the assets held by the corporation that have disappeared on wind-up or amalgamation.
As indicated above, where a corporation has borrowed to repurchase shares, the deductibility of the interest is related to the amount of the debt required to “fill the hole.” In the income trust conversion context, by inserting a holding corporation and having that corporation acquire the operating company shares, there is an acquisition of property for an income earning purpose and when the two corporations merge, a link is established between the acquisition of the operating company shares that disappear on the merger and the assets formerly held by that corporation that are now in the new operating corporation.
The CRA considers that paragraph 21 of IT-533 applies to the notes issued in the income trust conversion context. Thus, absent any issue concerning the reasonableness of the interest rate, in these and similar circumstances, the CRA permits the deduction of all interest paid or payable, without any restriction relating to the “fill the hole” concept.