The Interest Deductibility Interpretation in TDL: Some Wider Implications

The TCC decision in The TDL Group Co. v. The Queen (2015 TCC 60; under appeal), discussed in Alex Klyguine’s article above, presents some novel reasoning that could give rise to open questions on appeal. The primary issues are whether the income-earning test extends to capital gains, whether the relevant income-earning period is short-term or long-term, and what circumstances are relevant in determining whether there is an expectation of earning income.

The possible good news for taxpayers is that the court ruled that the reference to “income” in subparagraph 20(1)(c)(i) includes capital gains (paragraph 27), citing Ludco Enterprises Ltd. v. Canada (2001 SCC 62) as support for this position. This holding should be of particular interest to taxpayers borrowing to invest in non-dividend-paying common shares, because it contradicts the CRA’s longstanding position that interest paid on borrowed money used to invest in common shares is deductible only if there is at least a possibility of earning dividend income. However, Ludco could be given a different interpretation. The taxpayers in Ludco borrowed to invest in shares of companies and expected to earn capital gains and dividends, but the SCC focused on the dividend potential of the shares and ignored the potential for earning capital gains. This interpretation of “income” may also be problematic in light of subsection 9(3), which provides that “income from a property” does not include any capital gain from the disposition of that property.

A separate issue with TDL relates to the CRA’s choice of time period to reassess. TDL borrowed money from its parent and used that money to make a direct investment in common shares of the taxpayer’s subsidiary. It was initially intended that the subsidiary would use the proceeds of that loan to make an interest-bearing loan to the group’s parent; however, due to tax issues surrounding the payment of interest by the parent, the subsidiary initially made a temporary interest-free loan to the parent instead. When those tax issues were resolved, the interest-free loan was replaced with an indirect interest-bearing loan. The CRA denied TDL’s deduction of interest payable to its parent to the extent that such interest accrued while the subsidiary’s interest-free loan was outstanding, but it allowed TDL’s deduction of interest accruing after conversion to an indirect interest-bearing loan.

The court cited Ludco in holding that the purpose test “must be applied at the time the investment is made, namely at the date the [taxpayer] acquired the shares in [its subsidiary], and furthermore that ‘all the circumstances must be considered.’” Assuming that the quotation above is an accurate interpretation of Ludco, this statement seems to imply that the purpose of the taxpayer’s investment should not have been reconsidered when the indirect interest-bearing loan replaced the interest-free loan. Accordingly, the CRA’s position that interest was not deductible while the subsidiary’s interest-free loan was outstanding, but was deductible while the subsidiary’s indirect interest-bearing loan was outstanding, is inconsistent with the interpretation of Ludco quoted above. Although the deductibility of interest accruing while the indirect interest-bearing loan was outstanding was not before the court in TDL, it is perhaps surprising that the court did not address this inconsistency.

It appears to be more consistent with Ludco to consider whether, at the time TDL subscribed for common shares of its subsidiary, TDL had a reasonable expectation of income over the reasonably expected lifetime of its investment in those shares. Viewed in this way, the relevance of the temporary interest-free loan becomes less clear. TDL and its parent intended that the interest-free loan was to be replaced with an interest-bearing loan once it was determined how to do so on a tax-efficient basis. More broadly, it is not clear that the subsidiary’s use of the subscription proceeds should be relevant in determining the reasonable expectation of income on the subsidiary’s shares.

Josh Jones
Blake Cassels & Graydon LLP, Toronto
josh.jones@blakes.com

Canadian Tax Focus
Volume 5, Number 2, May 2015
©2015, Canadian Tax Foundation