14 May 2005 Internal T.I. 2008-0304841I7 - Interest deductibility

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: Whether interest on borrowings is deductible during the period when the borrower company is under the protection of Corporation's Creditors Arrangement Act ("CCAA").

Position: No

Reasons: Unless otherwise expressly mentioned in the Court order, there is no legal obligation to pay interest, during the period of suspension ordered by the CCAA

									May 14, 2009

Hamilton TSO- Large Case Section				V. Srikanth
55 Bay Street North, P.O. Box 2220
Hamilton ON L8N 3E1

Attention: Vinod Modi
									2008-030484

Interest accrual

We are writing in response to your e-mail dated December 5, 2008, concerning the accrual of interest, pursuant to paragraph 20(1)(c) of the Income Tax Act (the "Act"), during the period following the filing by a corporation under the Companies Creditors Arrangement Act ("CCAA").

The facts of the case can be generally summarized as follows:

XXXXXXXXXX ("CanOpco") is a 100% subsidiary of XXXXXXXXXX ("NRHoldco"). The NRHoldco is a US based corporation. In XXXXXXXXXX , the NRHoldco filed for protection under Chapter 11 of the U.S. Bankruptcy Code. On the same date, CanOpco filed for creditor protection under the CCAA. The stay order period under the CCAA was until XXXXXXXXXX . During the stay order period, CanOpco had accrued significant interest expense on inter-corporate loans. However, no amount was paid during that period. You have also mentioned that the accrued interest included interest on the unpaid amount of interest. Lastly, you provided a court order dated XXXXXXXXXX (the "Court Order") with respect to the CCAA proceedings.

Your question is for purposes of the interest expense deduction, pursuant to paragraph 20(1)(c) of the Act, whether CanOpco has a legal obligation to pay such an amount during the stay order period.

Our comments

Paragraph 20(1)(c) of the Act allows a taxpayer to deduct as interest on borrowed money, such amounts as paid or payable in the year, pursuant to a legal obligation, and which is used for the purpose of earning income from a business or property of the taxpayer.

Therefore, one of the conditions to claim an interest expense deduction, pursuant to paragraph 20(1)(c) of the Act, is the existence of a legal obligation to pay interest on the money borrowed, i.e., basically, there must be an obligation to pay on the part of the borrower, and a legally enforceable right to the interest on the part of the creditor.

Compound interest, i.e., interest on interest, is deductible pursuant to paragraph 20(1)(d) of the Act in the year in which it is actually paid. Specifically, paragraph 20(1)(d) refers to "an amount paid in the year pursuant to a legal obligation to pay interest on an amount that would be deductible under paragraph 20(1)(c) if it were paid in the year or payable in respect of the year."

The CCAA is a Federal Act that permits an insolvent company to come to an arrangement to settle its debts with its creditors. While negotiating a settlement, section 11 of CCAA imposes a stay of proceedings on all creditors. To participate in this settlement, the creditors are required to file a claim in accordance with section 12 of the CCAA. Section 12 reads as follows:

"For the purpose of this Act, "claim" means any indebtedness, liability or obligation of any kind that, if unsecured, would be a debt provable in bankruptcy within the meaning of the Bankruptcy and Insolvency Act".

For a claim to be provable in bankruptcy, subsection 121(1) of the Bankruptcy and Insolvency Act ("BIA") provides that the claim must be a debt or liability arising from an obligation incurred before the day on which the bankruptcy arose. Furthermore, subsection 122(2) of the BIA provides that interest on the amount owing is provable to the date of bankruptcy.

In Canada Deposit Insurance Corp. v. Canadian Commercial Bank (1994), 21 C.B.R. (3d) 12 (Alta.Q.B.), it was held that the division of the bankrupt's property was carried out as if frozen in time at the date of bankruptcy, and no interest accrued after that date.

The issue of charging interest, while the stay of proceedings was in effect, was resolved in Re Philip's Manufacturing Ltd. (1992), 12 C.B.R. (3d) 133 (B.C.S.C.), add'l reasons in (1992), 91 D.L.R. (4th) 766 (B.C.S.C.) aff'd in (1992), 12 C.B.R. (3d) 149 (B.C.C.A.), where it was held that, since the purpose of the stay of proceedings under the CCAA was to maintain the status quo, no interest was payable on claims during the period of the stay without a court order.

According to paragraph 20(1)(c) of the Act, the interest expense must, inter alia, be an amount paid during the year or payable for the year pursuant to a legal obligation to pay interest on money borrowed. In Barbican Properties Inc.v The Queen 97 DTC 122, Judge T.E. Margeson, made the following comments about contingencies and legal obligation to pay:

"When the Court asks the question, was the amount owing, it must conclude that it was not owing unless one of the conditions was met. Surely, where one clause in the agreement specifies a repayment clause where interest is calculable with certainty but another clause specifies that no interest is payable under the earlier clause unless certain conditions are met, there is no legal obligation to pay the interest until the conditions are met and the liability to pay is "contingent". Simply put, as argued by counsel for the Respondent, the bottom line was that the bank could not enforce payment."

In Redclay Holdings Ltd v The Queen 96 DTC 1207; [1996] T.C.J. No. 126, Judge Rip made the following comments on the issue of legal obligation to pay interest for the purpose of deduction provided in paragraph 20(1)(c) of the Act:

"The word "payable" means a sum of money that is to be paid or is falling due or "qui doit être payé". The word "payable" has also been described as a sum of money when someone is obliged to pay it. For purposes of paragraph 20(1)(c), an amount of interest must be payable in respect of the year pursuant to a legal obligation to pay it. An obligation to pay may be contingent on a particular event, future and uncertain, or a condition taking place and the amount of interest would be payable in the year when the event takes place or the condition is satisfied; the amount of interest would be deductible in that year, not the year in which the interest may be eventually paid."

Further commenting on this issue in the case at bar, Judge Rip said:

"Highmont had an obligation to pay principal and interest under the Copper Debentures. However, Highmont was not obligated to pay any amount of principal and interest in its 1986, 1987 and 1988 fiscal years. A debt existed; Highmont may have owed money to the creditors in the years in appeal but the interest was not yet payable. If the creditors asked Highmont for payment of the interest in those years, Highmont's reply would be "We owe you interest but we don't have to pay you yet. There has been no cash flow", and Highmont would be correct. Therefore how can the partners in Highmont deduct any amount? The amount of interest Highmont was obliged to pay in those years to the holders of the debentures was not known; Highmont was not liable for payment of an ascertained amount of interest. Highmont was obligated to pay interest in each year but the amount of the interest payable in the year could not be quantified because there was no cash flow. It is an amount that is quantified or ascertained in the year that is payable in the year and is deductible in computing income for that year for tax purposes."

In the given submission, CanOpco's legal obligation to pay interest expired on the day it obtained protection from its creditors under the CCAA. Beyond that day, the obligation to pay such interest could not exist because its creditors, by virtue of the stay proceedings, could not enforce payment. Therefore, as there is no legal obligation to pay interest during the stay order period, in our view, the debtor, i.e., CanOpco, cannot deduct any interest expense during that period pursuant to paragraph 20(1)(c) of the Act.

It should be noted that the accrual of interest is stayed during the period following the issuance of the stay of proceedings, unless otherwise ordered by the Court. An examination of the Court Order that was provided did not provide any evidence that CanOpco was ordered to pay interest on its loan to NRHoldco during the stay order period. However, for greater certainty, you may wish to contact the monitor for the CCAA proceeding to confirm the same. You have indicated in your submission that the accrued interest deducted by CanOpco for the years under review includes compound interest. The deduction of this can be denied under paragraph 20(1)(d) of the Act as, based on our comments above, there is no legal obligation to pay such interest during the stay order period. Further, no amount was paid in the year.

R.A. Albert, CA
For Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch