Cassan – Tax Court of Canada finds that interest should not be recognized on a portfolio or index-linked note until the return is determinable - and that lack of attention of a lender to creditworthiness established lack of bona fide repayment arrangements under s. 143.2(7)

In December 2009, individual taxpayers participated in a tax shelter that involved making both a leveraged investment and leveraged donation. In the investment component, they used money borrowed from a lender trust (FT) to purchase units in an Ontario LP, which used most of the proceeds to purchase notes of a BVI company (Leeward). The return on the notes was linked to whichever of a stock market index and a notional balanced portfolio performed the better, with Leeward then lending the funds back to FT via a second trust.

Respecting the leveraged donation, they borrowed money from FT at 7.85% p.a. – of which 3.75% p.a. was required to be paid annually in cash (“cash-pay interest”) and the balance was capitalized each year (“capitalized interest”). This borrowed cash was then contributed by them to a registered charity on condition that it invest most of such proceeds in a note of Leeward, that matured in 2028, and bore interest of 4.75%, of which 3.75% was cash-pay interest, and the balance capitalized interest of 1% (which would cause the amount owing under the note to accrete by over 1/3 by 2028). These funds also were mostly circled back to FT. The ability of Leeward to be able to repay this note owing to the charity depended on the small portion of the funds received by it from the individuals (via the LP) under the investment component, that it invested in a fully-indexed note rather than on-lending back to FT via the second trust, appreciating at a rate of 10% p.a. over the close to 20 years until 2028.

Owen J found that the taxpayers’ donation did not qualify as a “gift,” as “Maréchaux and Kossow hold that a transfer of property is not gratuitous if a benefit flows to the transferee as part of an interconnected series of transactions that includes the transfer of property.” The benefit he identified was that the interest rate of 7.85% that was charged to them was less than a reasonable rate of interest, which would have been a minimum of 10% p.a.

This issue was not fixed by the split receipting rules. It is true that having regard only to ss. 248(30)(a), (31) and (a), they could have been entitled to have a gift recognized for the difference between the cash contributed to the charity and the low-interest-rate benefit received from FT. The bigger problem was posed by the combined effect of s 248(32)(b) (deeming the amount of limited-recourse debt to be a benefit), s. 143.2(7)(a) (deeming debt to be limited-recourse if there were no bona fide arrangements for repayment within 10 years) and s. 143.2(12) (deeming there to be no such arrangement if the debtor’s arrangement to repay within 10 years “can reasonably be considered to be part of a series of loans or other indebtedness and repayments that ends more than 10 years after it begins.”) Although the loan from FT to them had a term of 9.3 years, Owen J found that this was insufficient to establish that there were bona fide arrangements for repayment which, in his view, required “that the arrangements reflect what one would reasonably expect arm’s length commercial relations to look like in the circumstances.” This was not the case here as the conduct of the lender (FT) showed relative indifference to the creditworthiness of the taxpayers. Furthermore, respecting s. 143.2(12), it was reasonable to expect the loans to the taxpayers to be renewed on their maturity with the promoter’s assistance.

In finding that Reg. 7000(2)(d) interest accrual did not apply to the index-linked note, Owen J stated:

The assumption underlying paragraph 7000(2)(d) is that [the maximum amount of interest] is capable of determination… .

…In the absence of an actual crystallizing event there is simply no way of knowing the actual amount that the … LP is entitled to be paid under the terms of the Linked Notes… .

In finding that the taxpayers were entitled to an interest deduction on their loans from FT, he noted that the potential for the receipt of interest on the maturity of their share of the Linked Notes held by the LP was sufficient to justify the deduction of interest by them for the 19 preceding years.

Neal Armstrong. Summaries of Cassan v. The Queen, 2017 TCC 174 under s. 118.1(1) – total charitable gifts, s. 143.2(7)(a), s. 143.2(12), Reg. 7000(2)(d), s. 20(1)(c)(i) and Statutory Interpretation – Realization Principle.