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Canada

11 March 2016

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Canadian Appeals Court Overturns Tax Court's Disallowance of Interest Deductions for Intragroup Loan

Canada's Court of Appeal has overturned a 2015 ruling by the Tax Court that disallowed an interest deduction by a Canadian subsidiary of the Wendy's/Tim Horton group (subsequently split) for an intragroup loan made in 2002.

Background

The case involved a series of transactions between 18 March 2002 and 27 March 2002 as follows:

  • Wendy's International Inc. (Wendy's), the ultimate parent of the group, loaned CAD 234 million to its U.S. subsidiary, Delcan Inc. (Delcan), at an interest rate not to exceed 7 percent.
  • Delcan then loaned the full amount to TDL Group Co. (TDL), the Canadian appellant in the case, at a rate of 7.125%.
  • TDL then used the full amount of the loan from Delcan to purchase additional common shares in its wholly-owned U.S. subsidiary, Tim Donut U.S. Limited, Inc. (Tim's U.S.).
  • Tim's U.S. then made an interest-free loan to Wendy's, evidenced by a promissory note.

Following the above series of transactions, Wendy's decided to have Tim's U.S. incorporate a new U.S. subsidiary, Buzz Co., in May 2002. The promissory note was then assigned to Buzz Co. as payment for Buzz Co.'s shares, and was repaid on 4 November 2002 through the issuance of a new note for CAD 234 million with an interest rate of 4.75%.

Following a review of the series of transactions, Canada's Revenue Agency disallowed TDL's claim for a deduction of the interest paid to Delcan for the period 28 March to 3 November 2002. This was appealed with the Tax Court.

The Tax Court found that there was no reasonable expectation of earning income at the time of the TDL's purchase of additional shares in Tim's U.S., and found that the sole purpose of the borrowed funds was to facilitate an interest free loan to Wendy's while creating an interest deduction for TDL. Since the Tax Court determined that TDL failed to meet the income earning purpose test, the disallowance of the interest expense for the period was upheld.

Court of Appeal Decision

The Court of Appeal found that the Tax Court had incorrectly applied the income earning purpose test. In particular, it questioned how the Tax Court determined that no income earning purpose existed for the transaction before 4 November 2002, but did exist after.

According to the Court of Appeal, the income earning purpose test is to be applied when the borrowed funds are used, which in this case was when TDL used the funds to acquire additional shares in Tim's U.S. It said that in this regard the Tax Court erred in determining that TDL needed a reasonable expectation of earning income in the first seven months of ownership of shares in Tim's U.S.

In addition, the Court of Appeal found that the temporary use of the funds as an interest-free loan to Wendy's did not detract from TDL's income earning purpose, and that the Tax Court erred in determining that the sole purpose of the borrowed funds was to facilitate an interest free loan.

Lastly, the Court of Appeal reviewed whether the amount of interest paid by TDL during the period was reasonable. It found that because National Revenue had accepted the interest rate paid to Delcan after the seven-month period as reasonable, then that same rate paid during the seven-month period is also reasonable.

Based on the above, the Court of Appeal has set aside the judgment of the Tax Court that disallowed the deduction.

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