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 CCRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.
Principal Issues: Whether a nil rate of interest is a reasonable rate for the purposes of subsection 17(1) of the Income Tax Act in the circumstances described in the memo.
Position: No.
Reasons: No arm's length person would lend money at a nil interest rate in the circumstances.
March 6, 2003
Mr. Paul Stesco Income Tax Rulings Directorate
Toronto West Tax Services Office International and Trusts Division
5800 Hurontario Street, 8th Floor S. Leung
Mississauga (Ontario) L5A 4E9 952-4666
2002-017835
Section 17 of the Income Tax Act (the "Act") XXXXXXXXXX
We are writing in reply to your letter of December 6, 2002, in which you requested our opinion as to whether subsection 17(1) of the Act would apply to the following situation. We also acknowledge the additional information you provided in your telephone conversation of February 11, 2003.
The Situation
1. On XXXXXXXXXX ("Forco"), a U.S. corporation, filed for relief under Chapter 11 of the U.S. Bankruptcy Code.
2. On the same date XXXXXXXXXX ("Canco"), a corporation resident in Canada and a wholly-owned subsidiary of Forco revoked its status as a non-resident owned investment corporation within the meaning of subsection 133(8) of the Act.
3. On XXXXXXXXXX, Canco lent CAN$XXXXXXXXXX and US$XXXXXXXXXX (in aggregate the "Loan") interest-free to Forco. The Loan was evidenced by an unsecured demand note.
4. On XXXXXXXXXX, the paid-up capital ("PUC") of the shares in Canco was CAN$XXXXXXXXXX. Given various security claims and the issues in obtaining debtor-in-possession financing, a return of PUC was not possible on that date.
5. Canco's fiscal year ends on XXXXXXXXXX. As of XXXXXXXXXX, the Loan was subject to subsection 15(2) and paragraph 214(3)(a) of the Act and Canco accordingly remitted the Part XIII withholding tax of CAN$XXXXXXXXXX on XXXXXXXXXX.
6. After Forco is out of the Chapter 11 protection, it is expected that Forco will request a refund of the Part XIII tax paid pursuant to subsection 227(6.1) of the Act because the amount due to Canco will be offset (repaid) by a return of PUC prior to the sale of the XXXXXXXXXX business of the Canadian subsidiaries of Forco and other related non-resident companies (the "Canadian operations") to a third party.
The taxpayer has argued that subsection 17(1) of the Act would not apply (note that the exception in subsection 17(7) would not apply where Part XIII tax was refunded pursuant to subsection 227(6.1) of the Act) because the interest rate of nil is a reasonable rate under the special circumstances of this situation. The taxpayer referred to two documents (#9032185 and #2002-0152203) issued by the Canada Customs and Revenue Agency (the "CCRA") to support their arguments. The first document seemed to accept the premise that nil could be "a reasonable rate" of interest in a particular situation. The second document indicated that a reasonable fee under a security lending arrangement is nil in situations where the lender is receiving a commercial benefit. The taxpayer then argued that the Loan provided an economic benefit to the Canadian operations in that the Loan provided liquidity to Forco thereby allowing for the orderly sale of the XXXXXXXXXX business of the Canadian operations. The orderly sale allowed the Canadian operations' XXXXXXXXXX business to continue to operate and conduct business without the risk and uncertainty that the Chapter 11 filing may have created for its customers, suppliers and employees. The debtor-in-possession financing of which the Loan is a part allowed Forco to market and seek out potential buyers of the XXXXXXXXXX business and the highest possible price for the Canadian operations. It is reasonable to conclude, according to the taxpayer, that the true value of the Canadian subsidiaries (including Canco) would not have been realized if the debtor-in-possession financing had not been obtained and Forco was liquidated in accordance with Chapter 7 of the Bankruptcy Code.
It should be noted that the above-noted CCRA documents referred to by the taxpayer involve parties that dealt with each other at arm's length which is not the case in this situation. The first document underscores that it is a question of fact whether a particular interest rate is a reasonable rate. It implies that in a very special situation involving parties who deal with each other at arm's length a reasonable rate of interest may be nil. The second document involves the determination of a reasonable fee for a security lending arrangement between two parties dealing with each other at arm's length which is in essence an arrangement to invest short-term cash by the "borrower/buyer" in a foreign country secured by the "borrowed" securities of the "lender/vendor". In that specific situation where the essence of the transaction is a commercial equivalent to a fully secured loan made by the "borrower" of the securities to the "lender", there is no reason for the "borrower" to pay a fee to the "lender" where (i) the "borrower" cannot resell or reregister the "borrowed" securities, (ii) all the income earned from the "borrowed" securities belongs to the "lender", and (iii) the "borrowed" securities have to be returned intact on the repurchase date. Therefore, where the arrangement meets those conditions specified in that document, the CCRA opined that a reasonable fee for the "use" of the security would be a nil amount.
As noted above, both these documents involve persons who deal with each other at arm's length. In documents #9127055 and #9230027, the CCRA stated that a reasonable rate of interest for the purposes of subsection 17(1) should in the circumstances of a particular case reflect the amount of interest the lender would expect to receive if the loan was made on an arm's length basis.
In the situation outlined in your letter, it is hard to imagine that an arm's length person would, in the light of the potential bankruptcy of the borrower, lend money to the borrower at no interest and with no security. We cannot ignore the importance of the relationship of the borrower and the lender in determining whether an interest rate is considered to be a reasonable one for the purposes of subsection 17(1) of the Act. Although subsection 17(9) of the Act is not applicable in this case, it does provide some insight on the significance of that relationship. In order for subsection 17(1) not to apply, paragraphs 17(9)(a) and (c) stress that the lender must not be related to the borrower and that the terms and conditions in respect of the amount owing must be such that persons dealing at arm's length would have been willing to enter into them at the time that they were entered into. Similarly, subsection 80.4(3) of the Act contains an exception to the application of subsections 80.4(1) and (2) of the Act. In order for subsections 80.4(1) and (2) not to apply, paragraph 80.4(3)(a) provides that the interest rate in respect of the loan or debt must be equal to or greater than the rate that would, having regard to all the circumstances, have been agreed on between parties dealing with each other at arm's length. It is, therefore, not unreasonable to consider these factors in determining what constitutes a reasonable rate of interest for the purposes of subsection 17(1) of the Act. Given the specific circumstances in this case, we do not feel that a nil rate of interest is a reasonable rate.
The CCRA has to be careful about accepting a taxpayer's "indirect benefit" argument where the parties involved are not dealing with each other at arm's length. Potentially there could always be arguments raised by a taxpayer that where a subsidiary lends money interest free to its shareholder, the subsidiary benefits somehow "indirectly" and consequently a less than fair market value interest rate is reasonable under the circumstances. Even if the CCRA were to accept that Canco has benefited "indirectly" from making the Loan (we are not conceding this point), the amount of the benefit is so subjective that, in our opinion, it should generally have no bearing on what would otherwise be a reasonable rate of interest. Furthermore, it should be noted that the taxpayer has not even shown how Canco (a financing vehicle), as opposed to the Canadian operating subsidiaries, would benefit from the loan. We have to recognize that Canco is a separate legal entity and the "indirect benefit" that its sister companies may receive may not necessarily benefit Canco.
In the situation at hand the benefit accrues to Forco directly. Any gain on the orderly sale of the XXXXXXXXXX business that the Canadian operations realized will ultimately accrue to the benefit of Forco and other shareholders of the Canadian subsidiaries. The primary purpose for the Loan is to assist Forco (Canco's sole shareholder) to get over its financial crisis. Canco, a wholly-owned subsidiary of Forco, likely had no choice but to make the Loan to Forco.
Conclusion
Based on all the above, we do not agree that a nil rate of interest is a reasonable one for the purposes of subsection 17(1) of the Act. We feel that subsection 17(1) is applicable in your situation. Even though the taxpayer could have made a return of PUC instead of making the Loan if the circumstances allowed them to do so, it is not this alternative way that the transaction was made and the tax has to be assessed based on how the transaction was actually carried out. Where, instead of making the Loan to Forco, Canco had paid an actual dividend to Forco, the dividend would have been subject to tax under Part XIII of the Act. The Loan was in fact a temporary strip of the Canadian assets to its U.S. parent and in policy terms subsection 17(1) should apply.
In this regard, it would not be uncommon for a Canadian subsidiary to choose to loan assets to its non-resident parent corporation as opposed to returning capital (for example, the Canadian corporation needs to maintain capital for thin capitalization purposes). Accordingly, a loan by a Canadian subsidiary to a non-resident parent corporation, regardless that the Canadian corporation has PUC that could be returned to the shareholder free of Canadian tax, is a transaction that is fully intended to be caught under subsection 15(2), 17(1) or 80.4(2), as the case may be.
We trust you find the above comments of some assistance.
Jim Wilson
Section Manager
for Division Director
International and Trusts Division
Income Tax Rulings Directorate
Policy and Legislation Branch
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