A family holding company that borrowed money to pay off a dissident shareholder and cancel her shares cannot deduct the $1.2 million in interest the firm paid on the loan, the Tax Court of Canada (TCC) has ruled.
Adding insult to injury, Justice Steven D’Arcy also denied a $51,963 deduction for legal and professional fees related to the corporate reorganization of A.P. Toldo Holding Corp.
The TCC ruled that acquiring shares for cancellation “can never be to gain or produce income from its business,” a key requirement for permitting a deduction for business expenses under the Income Tax Act (ITA): “This simply cannot happen if the shares are cancelled after they are purchased by the corporation.”
This case is a warning for tax planners to be careful when structuring a transaction to finance the takeout of a dissident shareholder in a multi-company family business.
The holding company’s principal assets were shares in four subsidiaries, which controlled eight other corporations that, the TCC’s ruling notes, “were worth a great deal of money” and had annual sales exceeding $131 million.
Anthony P. Toldo held 600 special shares in the holding company. His son, Anthony G. Toldo, and his daughter, Donna May Curlin, each held 100 common shares.
In 2005, a shareholder dispute arose. As a result, Curlin agreed to sell her shares to the holding company for $40 million and her husband agreed to sell his shares in one of the subsidiary companies for $6.75 million.
Under the agreement, the holding company bought 50 common shares for $20 million in cash and financed the other 50 shares with a series of promissory notes. The holding company also paid cash for the husband’s shares.
The holding company borrowed about $22.6 million from its affiliated companies, which held more than $164 million in cash at the end of 2005. The 100 shares bought from Curlin were cancelled.
On April 16, 2007, the holding company paid off the promissory notes for $21 million, which included interest, with cash generated by its subsidiaries and part of a bank loan.
The Ministry of Revenue Canada denied the holding company’s interest deduction on the promissory notes and some of the bank loan. The company appealed.
The company argued it was in the business of financing and banking for its subsidiaries and affiliated companies. So, under the ITA, the company was entitled to deduct the interest payments, either as a normal business expense under s. 9(1) or as an interest deduction under s. 20(1)(c).
The TCC’s ruling notes the lack of evidence on matters such as the holding company’s day-to-day operations, how it carried on its banking business and who acted on its behalf, and that it did not appear to have any employees.
The ruling notes that D’Arcy did not know what business the companies carried on or why they held such large amounts of cash. Based on the financial statements, the ruling says, the holding company didn’t have the resources to make substantial loans to the affiliated companies.
“At a minimum,” the TCC’s ruling concludes, “the appellant should have presented me with evidence that it lent money on a regular and continuous basis.” Rather, it was a “classic example of a holding company whose primary function is to hold shares in its subsidiaries and whose primary source of income is dividends from these shares… The interest was not paid in respect of money borrowed in the course of a money-lending business.”
As for the professional fees, the TCC determined they were “incurred in the course of acquiring a capital asset and must be recognized as having been incurred on account of capital” – which is treated differently than interest is under the ITA.
© 2014 Investment Executive. All rights reserved.