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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues: Is interest capitalized pursuant to subsection 18(3.1) of the Act deductible for purposes of subsection 212(13.2) of the Act

Position: Yes as part of the inventory when the units are sold

Reasons: ccm 9707797 9429875 and the wording of subsection 212(13.2) of the Act

February 24, 2000

	XXXXXXXXXX  Tax Services Office	Resources, Partnerships and
	International Audit	  Trusts Division
		Johanne Desparois, M.Fisc.
	Attention: XXXXXXXXXX
		1999-001425
		(7-993233)

T3 Trust Returns of XXXXXXXXXX

We are responding to your memorandum of December 1, 1999 concerning the interpretation of subsection 212(13.2) of the Income Tax Act (the "Act").

BACKGROUND

1. XXXXXXXXXX.

2. XXXXXXXXXX.

3. XXXXXXXXXX.

4. XXXXXXXXXX.

5. XXXXXXXXXX.

6. In XXXXXXXXXX the Trust claimed approximately $XXXXXXXXXX of non-capital losses with respect to its joint venture interest. All of the non-capital losses were created by the capitalized interest when the units were sold.

7. The Trust's representative was unable to provide any evidence that any interest or loan repayments were in fact made.

8. Part XIII tax was not withheld on the accrued interest during the construction period. However, it was withheld and remitted on XXXXXXXXXX in respect of the accrued interest for the post-construction period.

9. The Trust's representative mentions that Part XIII withholding taxes were not withheld in respect of the accrued interest during the construction period because such interest is required to be capitalized during the construction period, in accordance with subsection 18(3.1) of the Act and, therefore not deductible. Consequently, the Trust's representative concludes that subsection 212(13.2) of the Act is not applicable. The Trust's representative mentions that subsection 212(13.2) of the Act states that a non-resident payer of interest is deemed to be resident of Canada for purposes of subsection 212(1) of the Act but only to the extent that interest is deductible in computing that person's taxable income earned in Canada. Since interest is non-deductible by virtue of the requirement under subsection 18(3.1) of the Act during the construction period, the non-resident is not deemed by subsection 212(13.2) of the Act to be resident for purposes of subsection 212(1) of the Act and as such, the Part XIII tax does not apply.

Also, the Trust's representative relies on the decision rendered in the case of Minister of National Revenue v. Shofar Investment Corporation (79DTC 5347) (the "Shofar case") in support of his interpretation of the word "deductible".

YOUR QUESTIONS

10. Considering that capitalized interest was deducted in XXXXXXXXXX as part of the inventory cost when the units were sold, you requested that we reiterate your view by confirming that such interest is also deductible for the purposes of subsection 212(13.2) of the Act. Also, you requested a confirmation that pursuant to subsection 212(1) of the Act, the withholding tax would be due when the interest is actually paid.

11. You also requested our opinion as to whether the interest charged during the construction period could be denied, pursuant to paragraph 18(1)(a) of the Act, for any deduction of interest not actually paid to the lender.

OUR COMMENTS

12. Subsection 212(13.2) of the Act provides, inter alia, that where a non-resident carries on business principally in Canada and pays or credits to another non-resident an amount which was deductible in computing taxable income earned in Canada for any taxation year, the first mentioned non-resident is deemed to be a person resident in Canada in respect of that amount. Thus, where that amount is interest, it is subject to Part XIII tax pursuant to paragraph 212(1)(b) of the Act. We understand that the sole issue concerns the interpretation of the word "deductible" contained in subsection 212(13.2) of the Act. Therefore, we have assumed that the Trust is carrying on a business principally in Canada and that the Trustee has borrowed the funds from XXXXXXXXXX on behalf of the Trust.

13. Essentially, the position of the Trust's representative is that mandatory capitalized interest is not deductible in computing taxable income and therefore subsection 212(13.2) of the Act does not apply. We would agree with such a conclusion if the wording of subsection 212(13.2) of the Act would require that the amount be deductible in the taxation year where the amount is paid or credited. However, this is not the case. In fact, the wording of subsection 212(13.2) of the Act requires only that the amount "was deductible in computing taxable income for any taxation year". Thus, considering that the capitalized interest was added to the cost of inventory pursuant to subsection 18(3.1) of the Act and that it was deducted in XXXXXXXXXX when computing the Trust's taxable income arising from the sale of the units in those years, it is our opinion that such interest was deductible for the purposes of subsection 212(13.2) of the Act. In our view, our interpretation of that subsection is within the plain meaning of the words and is consistent with its application. Furthermore, it is our opinion that a court would be reluctant to conclude otherwise.

14. Also, the Trust's representative quotes the Shofar case as jurisprudential support for his interpretation of the word "deductible". The Shofar case deals with the application of former subsection 12(3) of the Act which read as follows:

"in computing a taxpayer's income for a taxation year, no deduction shall be made in respect of an otherwise deductible outlay or expense payable by the taxpayer to a person with whom he was not dealing at arm's length if the amount thereof has not been paid before the day one year after the end of the taxation year;..."

We do not agree that the reasoning applied in interpreting former subsection 12(3) of the Act can be applied in interpreting subsection 212(13.2) of the Act. In Shofar, the taxpayer, a trader in land, bought a piece of land in a non-arm's length transaction and resold the land when only a small part of the purchase price had been paid by the taxpayer. The question before the court was whether the price for which the property was purchased by the taxpayer was a "deductible outlay or expense". The Supreme Court of Canada quoted the decision rendered by the Federal Court of Appeal in the Oryx Realty Corporation v. Minister of National Revenue (74 DTC 6352) case (the "Oryx case"). In the Oryx case the Court explained that in the trading business, one of three methods may be used in computing gross profit for income tax purposes. One method is to add together the profit on each transaction. A second method is to aggregate the proceeds of all transactions and by deducting the aggregate costs of the things sold. Under these first two methods, the price for which the property was bought is deductible in computing gross profit. The third method is to deduct from the aggregate proceeds of all of the sales, the "cost of goods sold". The third method is generally used where due to the nature of the business, it is impossible or impractical to determine which goods were sold in the year and therefore it is impossible or impractical to determine their cost. Under the third method the cost of goods sold is computed by adding to the value placed on inventory at the beginning of the year, the cost of acquisitions during the year and deducting the value placed on inventory at the end of the year. Under the third method, in the computation of the taxpayer's gross profit there is no deduction of the specific cost of goods that were sold in the year. That is, there is no specific tracing of costs to the goods sold in the year. In order to have the same effect in the computation of a taxpayer's income regardless of the method used, the Federal Court of Appeal concluded, at page 6354, that former subsection 12(3) of the Act was not applicable in the Oryx case.

"Presumably, however, section 12(3) is to have the same effect in relation to the computation of a taxpayer's income for a year regardless of the method that has to be used to compute "gross profit". With considerable hesitation, I have come to the conclusion that section 12(3) should be interpreted, in the case of business income, as referring to the computation of "income" or "profit" for the year from the "gross profit" for the year; and was not, therefore applicable in the circumstances of this case. In reaching that conclusion, I am conscious that, in other contexts, for more than a century the general statements in the leading cases concerning business profits have treated the computation of profit as including the computation of gross profit. What has brought me to the opposite conclusion in the interpretation of section 12(3) is the necessity of giving such meaning to that subsection as will operate with consistency in the different circumstances to be encountered in the normal course of events."

The Supreme Court of Canada in Shofar agreed with the above conclusion rendered by the Federal Court of Appeal in the Oryx Case and thus, concluded that the cost of the taxpayer's land was not a "deductible outlay or expense" within the meaning of former subsection 12(3) of the Act. From the above comments rendered in the Oryx case it is quite obvious that the decision need not and should not be extended to other provisions of the Act unless the context otherwise requires. In fact, the Federal Court of Appeal consciously gave the words of former subsection 12(3) of the Act a somewhat strained interpretation in order to allow the provision to apply with consistency regardless of the method used by a taxpayer in computing gross profit from a business. It is our opinion that the word "deductible" used in subsection 212(13.2) of the Act is used in a much different context than it was in former subsection 12(3) of the Act. In former subsection 12(3) of the Act, the word "deductible" was used to qualify the expression "outlay and expense" whereas the word "deductible" does not qualify this expression in subsection 212(13.2) of the Act. It is therefore our view that the analysis provided by the Court in respect of former subsection 12(3) of the Act is not applicable in the context of subsection 212(13.2) of the Act and that the capitalized interest was deductible for the purposes of subsection 212(13.2) of the Act as the capitalized interest was deductible in computing the person's taxable income earned in Canada for any taxation year as required by this subsection.

Consequently, pursuant to subsection 212(13.2) of the Act, the Trust is deemed to be a person resident in Canada in the taxation year where it pays or credits the interest to XXXXXXXXXX and it shall withhold Part XIII tax on such interest in the taxation year in which it paid or credited the interest.

15. With respect to your question regarding whether the XXXXXXXXXX% rate was justified during the construction period, it is our view that since the loan was not guaranteed the lender would undoubtedly charge a higher rate then conventional mortgage type loan arrangements. However, since this is a factual determination, we suggest that you compare, if possible, the rate charged by chartered banks during those years for a similar loan arrangement before considering reducing the rate to XXXXXXXXXX%.

16. Also, you have mentioned that the Trust's representative was unable to provide evidence of any interest or loan repayments and you were considering whether you could deny any deduction pertaining to the interest.

Generally, subsection 18(3.1) of the Act provides that no deduction shall be made in respect of interest paid or payable on borrowed money used by a taxpayer in respect of the construction, renovation or alteration of a building. Such interest shall be included in computing the cost of the building.

XXXXXXXXXX

In our view, the fact that the interest was not paid is consistent with the loan agreement. Thus, considering that the interest was unpaid, the remaining unresolved issue for the purposes of subsections 18(3.1) and 18(3.2) of the Act is whether the accrued interest was payable within the meaning of these provisions.

It has been determined in Barbican Properties Inc. v. The Queen (97 DTC 5008) (the "Barbican case") that where the payment of interest is a "contingent liability", the interest is not considered to be "payable" for the purpose of paragraph 20(1)(c ) of the Act. However, where the payment of interest is only deferred to and payable at a particular time and there is no contingency component to the liability then the amount of interest is considered to be "payable".

In the Barbican case, the Federal Court of Appeal found that the amounts sought to be deducted were not payable in respect of the year because the payment of the amounts was dependent upon a contingency being satisfied prior to the payment. In the Barbican case, the taxpayer borrowed money to buy income-producing properties. Under the terms of the bank loans, the taxpayer was required to pay interest at a stipulated rate which accrued daily and was payable monthly. If the net operating revenues from any property in any year were insufficient to cover the interest payable in that year, the taxpayer was entitled to defer payment of that interest. Any deferred interest was due and payable at the latest upon the maturity of the loan, or upon the sale of the relevant property, whichever occurred first. However, if the capital appreciation of the properties were insufficient at the time of the sale it was possible to defer payment of the interest. The Federal Court of Appeal concluded that the deferred interest expense was not paid or payable in respect of the years for which they were claimed to be deductible, pursuant to a legal obligation to pay interest in accordance with paragraph 20(1)(c) of the Act and that such interest was a non-deductible contingent liability within the meaning of paragraph 18(1)(e) of the Act.

In the Barbican case, the Federal Court of Appeal mentioned that what was involved in that case was not a future liability. In the case of a future liability, there is certainty in respect of the payment of interest and only the time of payment is deferred. It is a real and existing liability but in the nature of a future obligation. Such payment is considered to be "payable" for the purposes of subsection 20(1)(c) of the Act.

Therefore, it is our opinion that clauses XXXXXXXXXX of the loan agreement provide for a future obligation which does not depend upon a contingency. The payment date which refers to the completion of the construction of the units simply defers the liability to a future time and, as such, is not a contingent liability. Therefore, although the interest was not paid during XXXXXXXXXX, such interest was "payable" within the meaning of subsections 18(3.1) and (3.2) of the Act. This opinion is based on the assumption that interest is only deferred until XXXXXXXXXX years after the completion date of the construction and the expression "completion date" is a definable event such as, the obtaining of relevant approvals from building inspectors/engineers. However, if the expression "completion date" has no particular significance, one could argue that the plain and ordinary meaning of "complete" must apply and therefore any minor unfinished construction may render the project incomplete and, as such, the event (i.e. completed construction) would be by no means certain to occur. In that last case the interest would not be deductible and therefore Part XIII tax would not be an issue.

Marc Vanasse, CA
Manager
Resources, Partnerships and Trusts Section
Income Tax Rulings Directorate
Policy and Legislation Branch

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