It is my understanding that the Canada Revenue Agency (“CRA” Canada) has not changed it’s position on the deductibility on interest incurred on borrowing to fund the redemption of shares or the payment of dividends.
Subparagraph 20(1)(c)(i) of the Income Tax Act (“ACT”) requires that the borrowed funds be used for earning income from business or property. The exception to the direct use of borrowed funds, is premised on the basis that the replacement of capital would quality if that capital was the borrowed money.
Basically, the replacement capital is the paid-up capital of the shares and accumulated profits or retained earnings. This makes sense in that if one used the original paid-in capital for the shares as opposed to borrowed money at the time the shares were issued or used accumulated profits in lieu of borrowed money to pay for the annual expenses that are inherent in the computation of the accumulated profits, that interest incurred on replacement thereof would be deductible.
For the redemption of shares, the deduction is limited to the portion of the borrowing that is equivalent to the paid-up capital and accumulated profits (retained earnings). For the payment of dividends, we would be looking at the accumulated profits at the time of the borrowing.
One should note that with regards to special shares that have high redemption value and low paid-up capital, say those issued as part of an estate freeze, it is the PUC that is used in determining the allowable interest deduction and not the redemption value.
Further guidance may be obtained by reading CRA Folio S3-F6-C1 which replaced ITB #533.