3 March 1997 External T.I. 9706235 - INTEREST ON PARTICIPATING LOANS

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:

Writer requested that we reconcile four court decisions dealing with the deductibility of interest expense and, in particular, participating interest: Redclay 96 DTC 1207, Barbican 96 2CTC 2615, Yonge-Eglinton 74 DTC 6180, Sherway Centre 96 DYC 1640.

Position:

Noted that, in order to be deductible as interest, the amount must satisfy the three criteria summarized in Miller 85 DTC 5354 and also the amount must be payable in respect of the year.

Reasons:

In both Redclay and Barbican the Court found that payment of the amounts depended upon a contingency and were not deductible. Sherway Centre decided on the same basis as Yonge-Eglinton but we have appealed.

	                         						970623
XXXXXXXXXX						                        J.P. Dunn

Attention: XXXXXXXXXX

March 3, 1997

Dear Sirs:

Re: Deduction of Interest on Participating Loans

We are writing in response to your correspondence of January 27, 1997 wherein you had requested clarification of the Department's position respecting the deduction of interest on participating loans in view of the comments of the Courts in a number of cases including Redclay Holdings Limited v. The Queen 96 DTC 1207, Barbican Properties Inc. v. The Queen (1996 2 CTC 2615), MNR v. Yonge-Eglinton Building Limited (74 DTC 6180) and Sherway Centre Limited v. The Queen (96 DTC 1640).

Although we are not able to comment directly on the hypothetical facts submitted with your correspondence, we would offer the following comments regarding interest deductibility in general.

As a preliminary comment, we would note that the deduction provided for in paragraph 20(1)(c) of the Income Tax Act is predicated on the basis that the amount sought to be deducted constitutes interest. At the 1989 Corporate Management Tax Conference, the Department noted that, on the basis of Brenda J. Miller v. The Queen (85 DTC 5354), in order to qualify as interest, an amount must satisfy all three of the following criteria;

(i) it must be calculated on a daily accrual basis,

(ii) it must be calculated on a principal sum or a right to a principal sum, and,

(iii) it must represent compensation for the use of the principal sum or the right to the principal sum.

Further, the amount to be deducted must be paid or payable in respect of the year for which the deduction is sought.

With respect to the Redclay and Barbican cases, the Courts, in each instance, found that the amounts sought to be deducted were not payable in respect of the year because the payment of the amounts was dependant upon a contingency being satisfied prior to the payment. In each of these cases, the amounts payable were implicitly acknowledged by the parties as constituting interest.

With respect to the Yonge-Eglinton case, the question to be resolved was the deductibility of amounts commonly referred to as participating payments. In that case, the Court found that the amounts in question did not constitute interest and, consequently, were not deductible as such. The amounts were, however, found to be deductible as expenses incurred in the course of borrowing money used for the purpose of earning income from a business or property. The Department commented on this case at the 1981 Conference of the Canadian Tax Foundation wherein it was noted that:

The payments in question were required irrespective of whether Yonge-Eglinton continued to owe money to Traders, were not related to any outstanding debt between the parties, and were payable whether or not any amounts were ever borrowed from Traders.

and further;

While the basis for payment was somewhat unorthodox, the payments themselves were in the nature of a commitment fee and did not represent compensation for borrowed money.

Accordingly, in that case, the amounts were not characterized as interest but rather as expenses incurred in the course of borrowing money and found to be deductible as such.

With respect to the Sherway Centre case, the Department considered that, while the amounts in question constituted compensation for the use of borrowed money, they did not accrue on a daily basis and, consequently, did not conform to the three criteria noted above and reassessed the taxpayer accordingly. Upon appeal, however, the Court found that the expenses claimed were similar to the amounts in the Yonge-Eglinton case as being expenses incurred in the course of borrowing money and that decision was cited as support for finding that the amounts were deductible pursuant to paragraph 20(1)(e) of the Act.

The Department has, however, appealed this decision.

We trust that this is the information which you require.

Yours truly,

Section Chief
Corporate Financing Section
Financial Industries Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch