12 February 2014 Internal T.I. 2012-0443391I7 - cross-border loans and deductibility of interest

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 payments on loan agreements which include certain equity like features are deductible under paragraph 20(1)(c)?

Position: Question of fact. General comments provided.

Reasons: The deductibility of interest under paragraph 20(1)(c).

February 12, 2014

XXXXXXXXXX Tax Services Office HEADQUARTERS
Audit Division Income Tax Rulings
Directorate
Attention: XXXXXXXXXX

2012-044339

XXXXXXXXXX("Canco")
Deductibility of Interest

This is in reply to your memorandum of April 19, 2012, wherein you requested that we provide you with an opinion as to whether the obligation created by a hybrid financing arrangement between Canco and its non-resident parent and a foreign subsidiary is debt or equity for purposes of the Income Tax Act (the "Act").

Summary of Facts

In XXXXXXXXXX, Canco received $XXXXXXXXXX US from its foreign parent ("Parentco"), for the purposes of subscribing for additional shares of XXXXXXXXXX ("Foreign Sub"), a newly acquired subsidiary of Parentco. The funds were used by Foreign Sub to purchase a XXXXXXXXXX company, XXXXXXXXXX ("MCo") from a third party. Once Foreign Sub purchased MCo, these two XXXXXXXXXX entities were then merged.

Facts

On XXXXXXXXXX, Parentco incorporated a Canadian subsidiary ("ULC") with a capital contribution of $XXXXXXXXXX.

On XXXXXXXXXX Canco purchased XXXXXXXXXX common shares of Foreign Sub from Parentco with XXXXXXXXXX shares issued as payment. The stated value of the purchased shares was $XXXXXXXXXX US. Foreign Sub was a subsidiary of Parentco operating in XXXXXXXXXX.

On XXXXXXXXXX, Canco received $XXXXXXXXXX US from Parentco to subscribe for XXXXXXXXXX additional shares of Foreign Sub. This was evidenced by a Term Debenture with the following terms and conditions:

XXXXXXXXXX.

With the funds from the share issuance, Foreign Sub purchased all of the outstanding shares of MCo from a third party on XXXXXXXXXX. Foreign Sub merged with MCo immediately after that.

It is the intention of the parties that the Term Debenture be treated as borrowed money in Canada with a claim for interest expense made annually by Canco. You indicate that the purpose of the transactions, as structured, leading up to the acquisition of MCo, is to obtain the tax benefit available in Canada from the interest deduction.

The following amounts were accrued at each respective year end and deducted as interest (CDN$):

XXXXXXXXXX - $XXXXXXXXXX
XXXXXXXXXX - $XXXXXXXXXX
XXXXXXXXXX - $XXXXXXXXXX
XXXXXXXXXX - $XXXXXXXXXX
XXXXXXXXXX - $XXXXXXXXXX

Each of the annual accrued liabilities was extinguished in the second subsequent year (i.e., XXXXXXXXXX interest payable was extinguished at the XXXXXXXXXX year end) by the issuance of shares. XXXXXXXXXX, was divided by the number of outstanding shares. This gives a per share value which is then used as the basis for determining how many shares are required to settle the liability. The following number of shares was issued:

XXXXXXXXXX – XXXXXXXXXX common shares in respect of the XXXXXXXXXX accrued liability
XXXXXXXXXX – XXXXXXXXXX common shares in respect of the XXXXXXXXXX accrued liability
XXXXXXXXXX – XXXXXXXXXX common shares in respect of the XXXXXXXXXX accrued liability
XXXXXXXXXX – XXXXXXXXXX common shares in respect of the XXXXXXXXXX accrued liability

The TSO review of the minute book in XXXXXXXXXX showed these amounts have been entered in the share register and actual share certificates were created and provided to Parentco. The share register shows Parentco long held XXXXXXXXXX common shares prior to these transactions. The share register adds an additional XXXXXXXXXX common shares issued to Parentco in the transaction in which Foreign Sub's shares were acquired by Canco from Parentco. There were a total of XXXXXXXXXX common shares held by Parentco as of XXXXXXXXXX. Parentco, throughout this time, held XXXXXXXXXX% of the Canco shares; there is no dilution or accretion in percentage share ownership by virtue of the additional issuances of shares.

You have asked for our views as to whether the payments may be re-characterized as payments made on equity rather than debt. You also asked whether such payments may qualify for an interest deduction under paragraph 20(1)(c) of the Act.

TSO Views

You indicate that US jurisprudence looks to the intention of the parties to create a debtor-creditor relationship. Debt is defined as existing when there is an "intention to create an unconditional obligation to repay." Among the factors considered by US courts are (1) whether there is an unconditional promise to pay a sum certain in money on a specific date, (2) the intent of the parties, and (3) the holder's right to enforce the payment of principal and interest. In your view, the offsetting agreements and limited recourse in this case have been planned so as to avoid creating an unconditional obligation to repay and avoid characterization of the underlying relationship as debtor-creditor.

In Canada, as stated in Shell Canada Limited v. Her Majesty the Queen 99 DTC 5669, legal relationships must be respected in tax cases and "a searching inquiry for… the "economic realities" of a particular transaction" will not be preferred to the application of an "unambiguous" provision of the Act to a taxpayer's transaction. However, in Shell itself, it is acknowledged that labels "attached by the taxpayer to the particular transaction [may] not properly reflect its actual legal effect." Where this is true, an analysis of the legal obligations created may properly lead to a recharacterization.

There may be a substance test in paragraph 20(1)(c) of the Act. This paragraph allows a deduction for interest on borrowed money. Jurisprudence referred to in IT-533 notes that this phrase should be interpreted to refer to funds received when it is established there has been a borrower and a lender relationship created in respect of those funds.

Our Comments

Characterizing financial instruments

At the 1995 Tax Executives Institute Round Table, the CRA stated:

"While the Act does deem payments of interest or dividends on certain financial instruments to be treated differently from their legal form (i.e. small business bonds, small business development bonds, income bonds and certain term preferred shares issued by non-residents) generally payments of interest or dividends usually derive their income tax consequences from the legal nature of the payment. This does not mean that the payments are not reviewable under the general anti-avoidance rule."

The Supreme Court of Canada ("SCC") considered the issue of economic substance and legal relationships in the case of Shell Canada Ltd v The Queen, [1999] 4 CTC 313. This case included consideration of an interest expense deduction under paragraph 20(1)(c) with respect to transactions that were entered into before the general anti-avoidance rule ("GAAR") in section 245 became effective. The SCC stated at paragraph 39 that "[r]echaracterization is only permissible if the label attached by the taxpayer to the particular transaction does not properly reflect its actual legal effect."

Accordingly, the CRA has not opined that cross–border tax arbitrage, in and of itself, would cause the re-characterization of the legal nature of a financial instrument. Whether the legal relationships are bona fide or whether GAAR may have application to a particular series of transactions requires a full examination of all the facts and circumstances of the particular case.

Interest - Paragraph 20(1)(c)

Generally, financing a business is considered a transaction on account of capital and except as otherwise stipulated under the Act, payments in respect of such financing would not be deductible pursuant to paragraph 18(1)(b). Paragraph 20(1)(c) provides a deduction for interest where certain conditions have been met and reads, in part, as follows:

"(c) Interest — an amount paid in the year or payable in respect of the year (depending on the method regularly followed by the taxpayer in computing the taxpayer's income), pursuant to a legal obligation to pay interest on

(i) borrowed money used for the purpose of earning income from a business or property (other than borrowed money used to acquire property the income from which would be exempt or to acquire a life insurance policy),
[…]

or a reasonable amount in respect thereof, whichever is the lesser;"

Meaning of interest

For an amount to be deductible under paragraph 20(1)(c), the amount must first qualify as interest. As indicated in paragraph 1 of IT-533, interest is not defined in the Act; however, for tax purposes, interest is generally accepted to mean an amount that has met the following three criteria:

• the amount must be calculated on a day-to-day accrual basis,
• the amount must be calculated on a principal sum (or a right to a principal sum), and
• the amount must be compensation for the use of the principal sum (or the right to the principal sum).

Where payments are dependent on cash flows, profit etc., these "participating payments" may not qualify as "interest" for the purposes of paragraph 20(1)(c) if they cannot be considered as paid on a day-to-day accrual basis and calculated on a principal sum, or a right to a principal sum. IT-533, dated October 31, 2003, included an update of the CRA's position with respect to participating payments for the purposes of paragraph 20(1)(c), which took into account the Federal Court of Appeal decision in The Queen v Sherway Centre Ltd, 98 DTC 6121 (FCA). Paragraph 2 of IT-533 expresses the following requirements in order for participating payments that are interest to be deductible under paragraph 20(1)(c):

• the payment is limited to a stated percentage of the principal (or the facts show that the payments are intended to increase the interest rate on the loan to the prevailing market rate);
• the limiting percentage of the principal, if any, reflects prevailing arm's-length commercial interest rates; and
• no other facts indicate the presence of an equity investment.

With respect to the meaning of prevailing market rate, paragraph 7 of IT-533 states: "The deduction for interest under paragraph 20(1)(c) is the lesser of the actual amount and a reasonable amount. In considering whether or not an interest rate is reasonable, consideration will be given to prevailing market rates for debts with similar terms and credit risks." For example, the limiting percentage may also reflect the risk that the lender may not receive all of the anticipated payments owing to insufficient profits in any one year.

In circumstances in which payments were determined as the lesser of a participation percentage and a stated percentage of the principal sum, the CRA has also accepted that such payments could constitute interest. For example, the CRA has accepted that a payment could constitute interest in a situation where interest paid on a percentage of net cash flow is subject to an overall limiting percentage of the principal sum of the debt that represents a commercial rate of interest.

Borrowed money

Pursuant to subparagraph 20(1)(c)(i), there must be a legal obligation to pay interest on "borrowed money", which requires that there be a borrower-lender relationship between the parties to the obligation. Paragraph 8 of IT-533 states: "In McCool, it was noted that the term borrowed money, in tax legislation, is interpreted to require "a relationship of lender and borrower between the parties." A requirement of a lender and borrower relationship is that there is a "loan" outstanding between the two parties. An essential element of a loan is that it must be subject to repayment. The CRA has provided favourable rulings that the borrower-lender relationship was not invalidated with respect to long-term debts if in the terms of the loan there was sufficient obligation for repayment at the maturity date.

We have reviewed the documentation you have submitted. It is our view that the features described therein, in and of themselves, would not cause the interest on the borrowed money to not be deductible pursuant to paragraph 20(1)(c) of the Act.

We trust our comments will be of assistance.

G. Moore
For Director
Reorganizations Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch