Tax Certainty Restored

Appeal court reaffirms interest deductibility in circular intra-corporate loan
REUTERS/Brendan McDermid
REUTERS/Brendan McDermid

Canada’s business community dodged a bullet when common sense prevailed in a recent Federal Court of Appeal decision dealing with the pervasive question of interest deductibility.

The FCA’s ruling in TDL Group Co. v. Canada overturned a Tax Court of Canada decision that had disallowed TDL, owner of Tim Hortons’ operations in Canada, a deduction for interest paid during the first seven months of an intra-corporate loan. The TCC reasoned that the loan had no income-earning purpose during this period despite the fact that the Canada Revenue Agency allowed TDL’s interest payments from the eighth month on.

“The Federal Court of Appeal concentrated on the big picture and adopted a pragmatic, business-like approach to the issue,” says William Innes of Rueters LLP. “Why should interest on the same money not be deductible for the first seven months of the loan but magically became deductible on day one of the eighth month?”

The case originated when parent company Wendy’s International Inc. lent $234 million to a US subsidiary, Delcan Inc., at a rate of interest that was not to exceed 7 per cent. The same day, Delcan lent an equal sum to TDL, another member of the group, at a rate of 7.125 per cent.

TDL used the money to purchase additional common shares in its wholly owned subsidiary, Tim Donut U.S. Ltd. Inc. The next day, Tim Donut lent the proceeds from the shares to Wendy’s on an interest-free basis.

But as noted by Justice Eleanor Dawson, writing for a unanimous bench composed also of Justices David Near and Richard Boivin, it was relevant that the loan to Wendy’s was always intended to be interest-bearing. The money was initially advanced on an interest-free basis because there were concerns about US state taxes and the application of Canada’s thin-capitalization rule. After seven months, the issues were resolved and the loan was restructured to bear interest from its inception.

The CRA, however, characterized the situation as a “money in a circle case” where money that Wendy’s lent out at 7 per cent was eventually returned to the parent company interest-free.

In a decision released in early March, the FCA disagreed with the CRA and the Tax Court. It recognized that the period that was initially interest-free and the interest-bearing period that followed were part of the same transaction.

“Given that the appellant’s purpose is to be assessed at that one point in time, an unanswered paradox runs through the reasons of the Tax Court: how is it that there was no income earning purpose during the first seven months the additional common shares were owned by the appellant, but an income earning purpose thereafter?” Dawson asked in her judgment.

As the FCA saw it, that made no business sense: the Tax Court had erred by importing a requirement that there be a reasonable expectation of TDL earning income from the share purchase within the first seven months of ownership.

According to Patrick Marley, a member of the Osler, Hoskin & Harcourt LLP team in Toronto that represented TDL on the appeal and had Al Meghji and Ilana Ludwin as counsel, a decision upholding the Tax Court would have augured badly for corporate taxpayers.

“One argument we made was that, if the Tax Court was right, taxpayers who borrowed money to buy shares in a company like Alphabet [formerly Google] that has never paid a dividend and has a policy of never paying them, could have its interest payments disallowed,” Marley says.

“The Tax Court’s reasoning could also be taken as suggesting that, whenever money was borrowed to buy shares of a public company or lend funds to a public company, inquiries might be required as to the purposes for which the money was to be used ­— and that is clearly unworkable.”

The Federal Court, then, returned the law concerning interest deductibility to what everyone thought it was. “The appeal reasoning is consistent with the Supreme Court of Canada’s guidance on interest deductibility and restores certainty to the law,” Marley says.