Canadian subsidiary may deduct interest on intercompany loan, court rules

by Carrie Smit

The Canadian Federal Court of Appeal on March 4 delivered its judgment in The TDL Group Co. v. The Queen (2016 FCA 67), holding that a Canadian company is entitled to deduct interest on a loan used to acquire shares of its US subsidiary. In so deciding, the Court overruled the Tax Court of Canada’s 2015 decision in the case.

In 2002 TDL borrowed Cdn$234 million indirectly from its US parent corporation, Wendy’s International Inc. (Wendy’s), and used those funds to subscribe for additional common shares of its wholly owned subsidiary, Tim Donut US Limited, Inc. (Tim’s US). Tim’s US then loaned the funds back to Wendy’s US on a non-interest bearing basis. After a seven month period, the loan from Tim’s US to Wendy’s was restructured and replaced with an interest bearing loan.

The Federal Court of Appeal disagreed with the Tax Court’s decision that the interest payable by TDL during this seven month period was not deductible.

Under paragraph 20(1)(c) of the Income Tax Act (Canada), interest is deductible if the borrowed money is “used for the purpose of earning income from a business or property.” Following a previous decision of the Supreme Court of Canada, the Federal Court of Appeal confirmed that this test looks only to the taxpayer’s purpose at the time the borrowed funds are used (i.e., when the Tim’s US shares were issued to TDL).

The Federal Court of Appeal found that it was paradoxical for the Tax Court to find that there was no income earning purpose during the first seven months, and then an income earning purpose thereafter. The Court held that paragraph 20(1)(c) does not require TDL to have had a reasonable expectation of receiving income on the new Tim’s US shares within the first seven months of ownership.

The Federal Court of Appeal also confirmed that paragraph 20(1)(c) does not encompass a tax avoidance element (presumably this is left for the General Anti-Avoidance Rule).  The Court cited the Supreme Court of Canada’s decision in Shell, to the effect that paragraph 20(1)(c) should be read in light of its “clear and unambiguous terms.”

This decision is a welcome one which eliminates much of the confusion created by the Tax Court of Canada relating to the appropriate application of paragraph 20(1)(c).

— Carrie Smit is a partner and head of the tax group at Goodmans LLP, Toronto. Her practice encompasses all aspects of income taxation that arise in corporate and commercial transactions, including cross-border mergers, corporate reorganizations, domestic and international debt financings, debt restructurings, and private equity investments.

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