Recent Tax Case: The TDL Group Co. v. The Queen, 2015 TCC 60By Robert Robillard - 19 March 2015
This blogpost originally appeared on rbrt.ca.
The TDL Group Co. v. The Queen, 2015 TCC 60 (CanLII) tax case pertains to the deductibility of interest paid for the alleged purpose of earning income from a business or property, that is paragraph 20(1)(c) of the Canadian Income Tax Act as it applied to a cross-border intercompany loan.
It is a tax case where a specific provision of the Canadian Income Tax Act prevails over the potential application of section 247 of the Act with respect to transfer pricing.
“ The Appellant, a Nova Scotia unlimited liability Company, appeals a reassessment denying interest deductions in respect of its 2002 taxation year totalling $10,094,856 on loans from a parent corporation used to acquire additional common shares in a U.S. wholly-owned subsidiary. The interest claimed and denied was in respect of interest paid for the period from March 28, 2002 to November 3, 2002 ( the “Period” ). The Minister of National Revenue (the “Minister”) disallowed the interest deduction pursuant to subparagraph 20(1)(c)(i) of the Income Tax Act (the “Act”) on the basis that the funds borrowed were not used for the purposes of earning income from a business or property; namely from a U.S. subsidiary’s shares acquired with the borrowed funds. Most of the relevant facts are not in dispute. A chronology of transactions started with Wendy’s International Inc. (“Wendy’s”), the ultimate parent of the group loaning $234,000,000 Cdn. ($147,654,000 US) to its U.S. subsidiary, Delcan Inc. (“Delcan”) before March 18, 2002 at an interest rate not to exceed 7 percent. Delcan in turn loaned the full amount to the Appellant on March 18, 2002 at a rate of 7.125 percent pursuant to a loan agreement and subsequently assigned this loan receivable to another affiliate in the group. The Appellant in turn used the full amount of the loan from Delcan to purchase 1,840 additional common shares in its already wholly-owned U.S. subsidiary, Tim Donut U.S. Limited, Inc. (“Tim’s U.S.”) on March 26, 2002 which in turn made an interest‑free loan to Wendy’s the next day, on March 27, 2002 evidenced by a Promissory Note dated as of that date (the “Note”). A schematic drawing of these transactions was entered as Exhibit R-1. In short, monies that started from Wendy’s was loaned out at interest and found its way back to Wendy’s interest free through these series of transactions. The evidence is that the Note was originally intended to be on an interest bearing basis according to planning memorandums entered into evidence, although no rate was specified, but that due to concerns an interest bearing note would have on state taxes in the U.S. and concerns with the Thin Capitalization and Foreign Accrual Property Income Rules in Canada under the Act, it was decided the loan would proceed on a non‑interest basis until the matter was sorted out.  Sometime in June of 2012, following a revised plan evidenced in May of 2012, Tim’s U.S. incorporated a new U.S. subsidiary, Buzz Co., which later changed its name to TD US Finance Co. (“Tim’s Finance”). Tim’s U.S. assigned the Note to Buzz Co. as payment for its shares in Buzz Co. and Buzz Co. then issued a Demand for Payment on the Note to Wendy’s which repaid the Note in full by issuing a new promissory note to Buzz Co. on November 4, 2002 (the “New Note”) for the same full amount bearing an interest rate of 4.75 percent, thus effectively replacing the non-interest bearing loan with a new interest bearing one. The delay in effecting these plan changes was explained by the preoccupation of the parties of the group in purchasing the interests of one of the group’s founders.  It should be noted that the Canada Revenue Agency (“CRA”) has in effect denied the Appellant the deduction of interest paid on its loan from Delcan during the Period, which coincides with the time the Appellant’s US subsidiary loaned the money back to Wendy’s on an interest free basis pursuant to the Note. Once the loan back to Wendy’s was effectively repaid and replaced with an interest bearing loan evidenced by the New Note, the Minister allowed interest deductibility from that date onwards.  Before proceeding on a further discussion of facts not agreed to or whose affects are disputed, I will briefly discuss the position of the parties and the provisions of the Act in play here as well as to give needed context to this dispute.”
“ There is no dispute as to the direct use of the borrowed funds so no issue of tracing the funds to the use in applying the “use” test arises as in the Bronfman Trust v The Queen, 1987 CanLII 76 (SCC),  1 SCR 32 case. The only issue in dispute is the “purpose”. In effect, the only question that must be answered here is whether the common shares were acquired for the purpose of earning non-exempt income.”
“ The Supreme Court informs us in Ludco as to the appropriate test for determining the purpose for interest deductibility under subparagraph 20(1)(c)(i) at paragraphs 54 and 55: It is clear from Ludco that the test must be applied at the time the investment is made, namely at the date the Appellant acquired the shares in Tim’s U.S., and furthermore that “all the circumstances must be considered”.”
54 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 a reasonable expectation of income at the time the investment was made.
55 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.
“ 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? I simply cannot agree this was a reasonable expectation of the Appellant at the time of such purchase for the following reasons:[..]
1. The Appellant was already the sole shareholder of Tim’s U.S. at the time of purchase of additional shares. The evidence is clear that Tim’s U.S. had lost substantial monies in the previous 4 years prior to the purchase date. The evidence is that the losses went from $12,000,000 in 1999, to $8,000,000 in 2000 to $4,000,000 in 2001 to $480,000 in 2002. Regardless of the obviously reversing trend which the Appellant points to, it is pretty clear Tim’s U.S. was not in a position financially to pay any immediate or short term dividends at the time of purchase of shares. This is particularly relevant when one considers that the loan evidence by the Note was only intended to be outstanding for a short period of time and was in fact only outstanding for about 7 months. There was also no history of payment of past dividends, obviously due to past losses at least in part.
2. The evidence of the Appellant’s own witnesses, namely P.H, the former CEO and T.M., the former CFO confirmed that the group had a policy of no returns on investments, i.e. dividends, until all capital expenditures were funded. The evidence from these witnesses and the 10 year plan submitted into evidence suggest at least a plan for substantial capital investments to increase the number of stores in the U.S. over the next 10 years. The net income projected from such increased stores shown on the plan for 2003 to 2010 are not projected to exceed the increase in capital expenditures for any years during that period, let alone in total so there is no indication of any monies being available for dividends during that period in light of the stated policy.
3. The 10 year plan itself has a line item for dividends to be paid and zero dividends were planned.
4. Notwithstanding that the Appellant has lead evidence showing dividends were in fact paid in 2007 to 2012, ranging from $100,000 per year from 2007 to 2009, $1,000,000 for each of 2010 and 2011 and $500,000 in 2012, the evidence is also that in 2006 the Tim Hortons group was spun out of the Wendy’s group and so a different ownership matrix applied that was not part of the circumstances at the time of the investment and no evidence was lead to suggest this was in the cards at the time of investing in the shares in 2002. If it was, one would think the projections on dividends in the 10 year plan would have showed it.
5. There is no mention of any potential for dividends to be paid in any of the planning memorandums of J.G., in any of the resolutions of the directors of the Appellant or Tim’s U.S. or Tim’s Finance (Buzz Co.) discussed in more detail later or anywhere else, let alone in the 10 year plan previously discussed.
6. The Appellant was already the sole shareholder of Tim’s U.S. at the time of purchasing additional shares in March, 2002. Whatever quantative income earning capacity or benefit it had per se in its capacity as sole owner did not change as a result of its new investment in Tim’s U.S. unless it can be demonstrated that the new investment could be expected to create or increase the chances for dividends or at least an increase in the value of its Tim’s U.S. shares. The fact the funds used to buy the new shares were immediately loaned to Wendy’s without interest for about 7 months after which funds were paid back in full suggests no obvious expectation that those funds created or were expected to create any income for Tim’s U.S. so as to increase its ability to pay dividends or increase the value of its shares for the future income benefit of the Appellant.
7. The funds loaned to Wendy’s on an interest free basis were also intended to be a short term temporary loan at the time of its advance. The Appellant’s own witnesses testified, as earlier mentioned, that they were aware the loan evidenced by the Note had to be reorganized and replaced and evidence from the planning memorandum of J.G., the tax advisor to the group indicates a revised plan as early as May 2002 that was put into effect resulting in the repayment of the Note in full in November of 2002, with delays explained due to the group’s preoccupation with other matters, including the repurchase of the shares of one of the Tim Horton’s group initial founders. The testimony explaining why there were delays in implementing the revised plan suggests it was the intention to loan funds out for an even shorter period of time. The testimony of the Appellant’s witnesses also confirmed that they knew of the potential tax problems above mentioned prior to the initial loan advance under the Note and that it had to be fixed thus the revised memorandum and repayment of the Note.
8. There is no credible evidence 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. […] [reasons 9 and 10 omitted here]
“ In analyzing all the evidence pertaining to the circumstances of this case, I simply cannot find that the Appellant had any reasonable expectation of earning non-exempt income of any kind, directly or indirectly, at the time of its purchase of additional shares in Tim’s U.S. on or about March 26, 2002.The evidence clearly and unambiguously only points to the sole purpose of the borrowed funds as being to facilitate an interest free loan to Wendy’s while creating an interest deduction for the Appellant. Accordingly, there is no need for me to consider the Respondent’s other argument that the interest in question would not be reasonable under the provision in issue.”
The complete case is available here.
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