3 June 2013 Internal T.I. 2012-0468131I7 - Participating debt 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: Is any amount of the Aggregate XXXXXXXXXX Amounts deductible as interest?

Position: Yes, the entire amount is interest and is deductible to the extent it is reasonable.

Reasons: Consistent with Sherway Centre, participating payments for amounts that are interest are deductible under paragraph 20(1)(c) where: 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.

June 3, 2013

XXXXXXXXXX HEADQUARTERS
XXXXXXXXXX TSO Income Tax Rulings
International Audit Directorate
L. Carruthers, CA
(613) 957-2113

2012-046813

XXXXXXXXXX (the "Taxpayer") – Whether amounts paid
to non-arm's length corporation resident in XXXXXXXXXX are interest

We are writing in response to your Memorandum dated October 30, 2012, in which you asked for our view as to whether any part of the Aggregate XXXXXXXXXX Amounts paid by the Taxpayer to its corporate non-resident parent ("ForParent") in XXXXXXXXXX and XXXXXXXXXX pursuant to the XXXXXXXXXX (the "XXXXXXXXXX Contracts") described below were interest for Canadian tax purposes. You also requested our view as to whether the time limitation in paragraph XXXXXXXXXX of Article XXXXXXXXXX of the Canada-XXXXXXXXXX Treaty (the "Treaty") would apply if we concluded that any part of the Aggregate XXXXXXXXXX Amounts were not interest.

Unless otherwise stated, all capitalized terms used herein that are defined in the XXXXXXXXXX Contracts have the meaning given in such definition.

Facts

Our understanding of the facts described in your referral and its attachments is as follows:

• ForParent is a corporation resident in XXXXXXXXXX for the purposes of the Treaty and owns all of the issued and outstanding shares of the Taxpayer which is a corporation resident in Canada.
• The Taxpayer is the parent company of several corporations resident in Canada in the XXXXXXXXXX Group. The Taxpayer is also the majority partner (XXXXXXXXXX%) of XXXXXXXXXX, the major operating entity within the Canadian resident XXXXXXXXXX group.
• The XXXXXXXXXX Contracts created on XXXXXXXXXX, were created and given by the Taxpayer to ForParent as part of the consideration for the Taxpayer's purchase of all of the issued and outstanding shares legally and beneficially owned by ForParent of
• XXXXXXXXXX
• respectively.
• The XXXXXXXXXX Contracts rank equally with each other and each XXXXXXXXXX Contract constitutes an unsecured obligation of the Taxpayer to pay a Face Amount which is subordinate to all senior indebtedness, including any other current or future debt, liability, or obligation of the Taxpayer in each case whether outstanding at the date of original issue of a XXXXXXXXXX Contract or thereafter incurred. Each XXXXXXXXXX Contract has a XXXXXXXXXX year term to maturity.
• Each XXXXXXXXXX Contract is convertible, at ForParent's discretion, into a fixed number of the Taxpayer's Common Shares (the number of Conversion Shares). The number of Conversion Shares is intended to represent the quotient of the Face Amount of the XXXXXXXXXX Contract divided by the fair market value of one Common Share as of the date the XXXXXXXXXX Contract was created.
• Each XXXXXXXXXX Contract requires the Taxpayer, on each XXXXXXXXXX Payment Date, to pay ForParent the Aggregate XXXXXXXXXX Amount (being the sum of the Fixed XXXXXXXXXX Amount and the Variable XXXXXXXXXX Amount) and the XXXXXXXXXX Amount, if any, for each XXXXXXXXXX Determination Period.
• The Fixed XXXXXXXXXX Amount of a XXXXXXXXXX Contract is equal to the Face Amount multiplied by the Fixed XXXXXXXXXX Rate for the particular XXXXXXXXXX Determination Period. The Fixed XXXXXXXXXX Rate for the XXXXXXXXXX Contract created on XXXXXXXXXX is the Government of Canada Yield plus XXXXXXXXXX basis points per annum, respectively. The Government of Canada Yield is determined in reference to actively traded on-the-run Government of Canada securities having a 30 year term to maturity.
• The Variable XXXXXXXXXX Amount of a XXXXXXXXXX Contract is equal to the lower (but not less than zero) of:

1. The Face Amount multiplied by the Variable XXXXXXXXXX Rate (which is XXXXXXXXXX% per annum), and

XXXXXXXXXX

• XXXXXXXXXX
• The Taxpayer has the option, at its discretion, to satisfy any part of an Aggregate XXXXXXXXXX Amount payable by issuing to ForParent preferred shares having an aggregate subscription price equal to the portion of the Aggregate XXXXXXXXXX Amount which such Share Payment Election relates. XXXXXXXXXX. The preferred shares issued are issuable at a face amount and subscription price of $XXXXXXXXXX per share, are entitled to a XXXXXXXXXX dividend, earn dividends that are payable in cash, in kind, or in additional preferred shares, are retractable and redeemable, and have voting rights.
• The Taxpayer expensed as interest Aggregate XXXXXXXXXX Amounts of $XXXXXXXXXX and $XXXXXXXXXX in XXXXXXXXXX and XXXXXXXXXX, respectively. The Taxpayer remitted Part XIII withholding tax at a rate XXXXXXXXXX% on these amounts. This is the appropriate withholding rate for interest pursuant to the Treaty.
• For XXXXXXXXXX tax purposes, ForParent classified the Aggregate XXXXXXXXXX Amounts earned pursuant to the XXXXXXXXXX Contracts as distributions from hidden capital contributions. As a consequence, no XXXXXXXXXX net worth tax, corporate income tax, or municipal business tax has been paid in respect of the XXXXXXXXXX Contracts.
• The Taxpayer later amended the XXXXXXXXXX deduction for the Aggregate XXXXXXXXXX Amounts paid to ForParent to be $XXXXXXXXXX which, according to the Taxpayer's Notice of Objection, reflects an Aggregate XXXXXXXXXX Amount payable expressed as a percentage of the relevant Face Amount under the XXXXXXXXXX Contract created on XXXXXXXXXX, of XXXXXXXXXX, respectively.

Your Request

You asked for our view whether:

(1) any or all portion of the Aggregate XXXXXXXXXX Amounts paid by the Taxpayer were interest,

(2) the Aggregate XXXXXXXXXX Amounts paid by the Taxpayer were reasonable; and

(3) a reassessment, if any, of any amounts that are considered non-deductible, either because they are not characterized as interest or because they are not reasonable, would be subject to the time limitation in paragraph XXXXXXXXXX of Article XXXXXXXXXX of the Treaty?

Your View

The Variable XXXXXXXXXX Amount of each XXXXXXXXXX Contract is essentially the lesser of XXXXXXXXXX% of the Face Amount and a fraction of non-consolidated net income of the Taxpayer after income taxes and after reversing all accruals under the XXXXXXXXXX Contract. Thus, this component could range from XXXXXXXXXX% to XXXXXXXXXX% of the Face Amount.

You specifically questioned whether this component of the Aggregate XXXXXXXXXX Amount was "referable to a principal sum" which you indicated was an essential criterion for an amount to be deductible as interest pursuant to paragraph 20(1)(c) of the Income Tax Act (the "Act").

Our Comments

We would draw your attention to the following paragraphs of Interpretation Bulletin IT-533 Interest Deductibility:

¶ 1. "Interest" is not defined in the Act but has been addressed in several court decisions, including Shell, Sherway Centre and Miller. As in Miller, interest for tax purposes is generally accepted to mean an amount that has met three criteria. These criteria are that 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).

¶ 2. Consistent with Sherway Centre, participating payments for amounts that are interest are deductible under paragraph 20(1)(c) where:

• 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.

The Variable XXXXXXXXXX Amount for each XXXXXXXXXX Contract is limited to XXXXXXXXXX% of the Face Amount, i.e., it is limited to a stated percentage of the amount of the principal. Furthermore, in our view, there are no facts indicating that the XXXXXXXXXX Contracts are equity investments. None of ForParent's ability to convert the XXXXXXXXXX Contracts into Common Shares of the Taxpayer, the Taxpayer's ability to satisfy the Aggregate XXXXXXXXXX Amounts payable through the issuance of Preferred Shares, nor ForParent's classification of the amounts received for XXXXXXXXXX tax purposes as distributions from a hidden capital contribution indicate the presence of an equity investment for Canadian domestic tax purposes.

Therefore, in response to your first question, to the extent the Aggregate XXXXXXXXXX Amounts expressed as a percentage of the relevant Face Amount under the XXXXXXXXXX Contracts (i.e., XXXXXXXXXX) reflect commercial interest rates between parties that are at arm's length at the time when the XXXXXXXXXX Contracts were executed, the $XXXXXXXXXX and $XXXXXXXXXX claimed by the Taxpayer in XXXXXXXXXX and XXXXXXXXXX, respectively, would be deductible pursuant to paragraph 20(1)(c) of the Act.

As noted in paragraph 7 of IT-533:

¶ 7. 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, and the existence of any issue premiums-see ¶ 38. Further, as stated in Shell, "Where an interest rate is established in a market of lenders and borrowers acting at arm's length from each other, it is generally a reasonable rate...."

Furthermore, the limiting percentage may reflect any increased credit risk arising as a result of the credit rating of the borrower and may also reflect the risk that the lender may not receive all of the anticipated payments due to the debtor's insufficient profits in any one year.

In response to your second question, we are not in a position to determine whether the XXXXXXXXXX rates described above reflect the commercial interest rates that prevailed between arm's length parties at the time the XXXXXXXXXX Contracts were executed and, therefore, we are unable to express a view as to the reasonableness of the Aggregate XXXXXXXXXX Amounts claimed by the Taxpayer in XXXXXXXXXX and XXXXXXXXXX.

In response to your third question, pursuant to paragraphs XXXXXXXXXX of Article XXXXXXXXXX of the Treaty, if a reassessment of Canco were warranted as the result of the conditions made or imposed between ForParent and Canco regarding the XXXXXXXXXX Contracts having been different from those which would have been made between independent enterprises, such a reassessment would be subject to the time limitation period in paragraph XXXXXXXXXX of Article XXXXXXXXXX of the Treaty. Therefore, if a reassessment of Canco were to be warranted because of your determination that the XXXXXXXXXX rates described above did not reflect the commercial interest rates that prevailed between arm's length parties at the time the XXXXXXXXXX Contracts were executed, such a reassessment would be subject to the time limitation period in paragraph XXXXXXXXXX of Article XXXXXXXXXX of the Treaty (i.e., XXXXXXXXXX years from the end of the year in which the denied interest had been deducted by Canco).

However, if under different circumstances a reassessment to deny the deduction of any portion of the Aggregate XXXXXXXXXX Amounts had been warranted because the XXXXXXXXXX Contracts were a commercially common instrument which would be classified as an equity investment even if it were entered into between independent enterprises, in our view, such a reassessment would not be subject to the time limitation period in paragraph XXXXXXXXXX of Article XXXXXXXXXX of the Treaty because it would not be as the result of conditions made or imposed between the two enterprises in their commercial or financial relations which differed from those which would be made between independent enterprises.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. A severed copy may also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the electronic library version, or they may request a severed copy using the Privacy Act criteria, which does not remove client identity. You should make requests for this latter version to Ms. Celine Charbonneau at (613) 952-1361. A copy would be sent to you for delivery to the client.

Olli Laurikainen, CPA, CA
for Director
International Section II
International Division
Income Tax Rulings Directorate