24 March 2004 External T.I. 2003-0020781E5 - XXXXXXXXXX

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: i) Is a payment under a swap agreement for the use of posted collateral, a payment exempted from Part XIII tax by clause 212(1)(b)(ii)(C) of the Income Tax Act (the "Act")?

ii) Are the payments made in respect of "debt-claims of every kind" as the term is used in Canada's income tax treaties?

iii) XXXXXXXXXX
iv) XXXXXXXXXX

Position: i) Cannot determine without reviewing the particular swap agreement.

ii) Cannot determine without reviewing the particular swap agreement.

iii) Not generally.

iv) Yes.

Reasons: i) and ii) Swaps can be structured in different manners to achieve the same result.

iii) XXXXXXXXXX
iv) XXXXXXXXXX

XXXXXXXXXX 								2003-002078
T. Cook
March 24, 2004

Dear XXXXXXXXXX:

Re: XXXXXXXXXX

We are writing in response to your letter of May 23, 2003, which requested our opinion on certain issues arising in connection with swap transactions entered into by XXXXXXXXXX. We apologize for the delay in replying.

Facts

You have provided us with the following information.

XXXXXXXXXX

Issues

You have raised four issues, and have asked us to consider each one independently of the others:

a) Does cash collateral posted with XXXXXXXXXX under a CSA constitute an obligation of one of the types set out in clause 212(1)(b)(ii)(C) of the Income Tax Act (the "Act")?

b) Does posted collateral constitute "debt-claims of every kind" as the term is used in the definition of "interest" found in most of Canada's income tax treaties?

c) Does the exemption with respect to the government of a Contracting State provided in the interest article of some of Canada's income tax treaties (e.g., those with France and Germany) apply to XXXXXXXXXX?

d) Is XXXXXXXXXX an instrumentality of Canada for purposes of paragraph 3(c) of Article XI of the Canada-U.S. Income Tax Convention (1980) (the "U.S. Convention")?

Our Comments

Your letter describes factual situations involving a specific taxpayer. As explained in Information Circular 70-6R5, it is not our practice to comment on the tax consequences applicable to a specific taxpayer in particular circumstances except in the form of an advance income tax ruling. We can, however, offer the following general comments.

a) Nature of the Payment

An exemption from Part XIII tax is found in clause 212(1)(b)(ii)(C) and in order for it to apply, certain elements must be present:

• interest must be payable;
• the interest must be payable on an obligation issued after April 15, 1966 that qualifies as "bonds, debentures, notes, mortgages, hypothecary claims or similar obligations"; and
• the obligation must meet the criteria set out in any one of subclauses 212(1)(b)(ii)(C)(I) to (V) of the Act.

Your letter states that amounts paid by the Secured Party (the "Payments"), presumably in compensation for the use of the cash collateral by the Secured Party, would be interest (see paragraph 9 above). Then you have asked us whether such interest would be paid on "bonds, debentures, notes, mortgages, hypothecary claims or similar obligations". Unfortunately we cannot give you a definitive answer. Swap transactions can use different structures to achieve a particular result, and consequently, it is not clear to us without having examined the documents for a particular transaction, whether the Payments would be interest for purposes of the Act, or amounts that could be deemed to be interest (e.g., pursuant to paragraph 214(15)(b) of the Act). For the same reason, we cannot comment on whether the Payments would be paid on bonds, debentures, notes, mortgages, hypothecary claims or similar obligations.

You have referred to technical interpretation #2000-0050975, which considered the Part XIII implications arising from certain risk mitigation payments made under a swap agreement. Our response is similar to the one expressed in that technical interpretation. Firstly, it was not clear in that technical interpretation whether the amounts payable would be interest, and if they were interest, a second determination would still need to be made regarding the basis upon which that interest arose. The fact that interest is payable may provide an argument in support of the view that it is payable on a bond, debenture, note, mortgage, hypothecary claim or similar obligation; but it is not determinative, particularly when the nature of the obligations listed in clause 212(1)(b)(ii)(C) is compared to the nature of a conditional requirement to post collateral.

XXXXXXXXXX.

If XXXXXXXXXX makes Payments to a non-resident and they are not interest or deemed interest, it is likely that the Payments would instead be business income to the recipient and that no Part XIII tax liability would attach. Where Payments by XXXXXXXXXX are interest, they would be exempt from Part XIII if the interest is payable on a bond, debenture, note, mortgage, hypothecary claim or similar obligation. Therefore, a Part XIII liability would likely arise only in the situation where interest or deemed interest is payable in respect of an obligation other than a debenture, note, mortgage, hypothecary claim or similar obligation. In light of our limited comments, XXXXXXXXXX may wish to consider requesting an advance income tax ruling, which would allow us to analyze the documentation for a particular swap transaction.

b) Debt-Claims of Every Kind

You have also asked whether the Payments would be made in respect of "debt-claims of every kind" as that term is used in Canada's income tax treaties. We presume you wish to determine whether the Payments fall within the ambit of Article 11 (Interest) of Canada's income tax treaties. This issue is relevant if under a swap, interest or deemed interest has been paid for purposes of Part XIII but it was not paid on "bonds, debentures, notes, mortgages, hypothecary claims or similar obligations." We note that paragraph 21.1 of the OECD Commentary on Article 11 of the OECD Model Convention states that the definition of "interest" in the OECD Model Convention does not normally apply to payments made under certain kinds of non-traditional financial instruments where there is no underlying debt (e.g., interest rate swaps).

The term "debt-claims of every kind" is very broad; however as set out above, we cannot express a view on the characterization of elements of a swap transaction in the absence of its particular details. But we can say that where the definition of interest in the relevant treaty includes "income assimilated to income from money lent by the taxation law of the State in which the income arises" (e.g., the Canada-France Tax Convention (the "French Convention") and the U.S. Convention), our view is that any amount that is interest or is deemed to be interest for Part XIII purposes would also be interest for purposes of that treaty.

c) Characterization of XXXXXXXXXX for Purposes of Canada's Income Tax Treaties

Your last two questions are really parts of a single question - how should XXXXXXXXXX be characterized under Article 11 of Canada's income tax treaties, with three specific examples (those tax treaties with Germany, the United States and France)? Canada's income tax treaties usually provide special rules for the taxation of interest arising from obligations of one Contracting State (and sometimes specified entities) paid to a resident of the other Contracting State, or the taxation of interest paid to a Contracting State (and sometimes specified entities). The treaties do not use consistent wording - a particular treaty may refer to the "government of a Contracting State" or "a Contracting State", or it may refer to a Contracting State/government of a Contracting State and then enumerate specific entities XXXXXXXXXX.

Whether "government of a Contracting State" or "a Contracting State" is used in these special rules should not change their interpretation. References to "government of a Contracting State" and "a Contracting State" can both be read fairly as references to the "government of Canada" where appropriate in Article 11 of an income tax treaty. Canada's income tax treaties do not define "government of Canada", or "Canada" except in the geographical sense. The approach for giving meaning to undefined terms is normally set out in paragraph 2 of Article 3 of the particular treaty. For example, the French Convention provides that:

any term not defined therein shall, unless the context otherwise requires, have the meaning which it has under the law of that State concerning the taxes to which the Convention applies, any meaning under the applicable tax laws of that State prevailing over a meaning given to the term under other laws of that State.

Similarly, section 3 of the Income Tax Conventions Interpretation Act (the "ITCIA") states:

Notwithstanding the provisions of a convention or the Act giving the convention the force of law in Canada, it is hereby declared that the law of Canada is that, to the extent that a term in the convention is

(a) not defined in the convention,

(b) not fully defined in the convention, or

(c) to be defined by reference to the laws of Canada,

that term has, except to the extent that the context otherwise requires, the meaning it has for the purposes of the Income Tax Act, as amended from time to time[.]

Therefore, Canadian tax law must be referred to in attempting to give meaning to "government of Canada" for the purposes of any special rules contained in the interest article of Canada's tax treaties, unless the context otherwise requires. The Federal Court of Appeal recently applied the ITCIA in Beame v. The Queen, [2004] F.C.A. 51. In that decision, the Court used the meaning of the term "income" that could be derived from the Act, even though the term is not defined in the Act. The term "Government of Canada" is not defined in the Act, but it is used in subclause 212(1)(b)(ii)(C)(I). XXXXXXXXXX

The domestic meaning of a term cannot be imported into a tax treaty though, if the context of the treaty otherwise requires. This exception is found both in Canada's treaties and in the ITCIA (see above). It is our view that the context of Canada's income tax treaties does generally require a meaning for "government of Canada" that is independent of the meaning the term has for purposes of the Act. For example, consider the Canada-Federal Republic of Germany Tax Agreement (the "German Convention").

German Convention

The relevant part of Article 11 of the German Convention provides:

3. Notwithstanding the provisions of paragraph 2, interest arising in a Contracting State and paid to a resident of the other Contracting State who is the beneficial owner thereof shall be taxable only in that other State to the extent that such interest:

(a) ... ;

(b) is paid in respect of indebtedness of the government of a Contracting State or of a "Land", or political subdivision or local authority thereof;

(c) is paid to the Canadian Export Development Corporation [now Export Development Canada] or to the German "Kreditanstalt für Wiederaufbau" or the "Deutsche Gesellschaft für Wirtschaftliche Zusammenarbeit";

(d) is paid to the government of a Contracting State or of a "Land", or political subdivision thereof, or to the central bank of a Contracting State; or ... [.]

XXXXXXXXXX

U.S. Convention

The relevant part of paragraph 3 of Article 11 of the U.S. Convention states:

3. Notwithstanding the provisions of paragraph 2, interest arising in a Contracting State shall be exempt from tax in that State if:

(a) the interest is beneficially owned by the other Contracting State, a political subdivision or local authority thereof or an instrumentality of such other State, subdivision or authority, and is not subject to tax by that other State;

(b) the interest is beneficially owned by a resident of the other Contracting State and is paid with respect to debt obligations issued at arm's length and guaranteed or insured by that other State or a political subdivision thereof or an instrumentality of such other State or subdivision which is not subject to tax by that other State;

(c) the interest is beneficially owned by a resident of the other Contracting State and is paid by the first-mentioned State, a political subdivision or local authority thereof or an instrumentality of such first-mentioned State, subdivision or authority which is not subject to tax by that first-mentioned State; ... [.]

This paragraph provides special rules for interest paid or received by a Contracting State and instrumentalities of that Contracting State. XXXXXXXXXX

French Convention

You have also asked for our comments on the application of the French Convention to XXXXXXXXXX in the context of the swap transactions described above. The relevant portion of paragraph 4 of Article XI of the French Convention provides:

4. Notwithstanding the provisions of paragraph 2,

(a) interest arising in a Contracting State [i.e., Canada] and paid to a resident of the other Contracting State [i.e., France] who is the beneficial owner thereof in respect of a bond, debenture, or similar obligation of a Contracting State [i.e., Canada] or of a political subdivision or local authority thereof, shall be taxable only in that other State [i.e., France];

(b) interest arising in France and paid to a resident of Canada shall be taxable only in Canada if it is paid in respect of a loan made or guaranteed, or of a credit granted or guaranteed, by the Export Development Corporation; ... [.]

In the absence of a particular example showing otherwise, we would expect your question to be moot in the context of the French Convention. The rule in paragraph 4(a) of Article XI only applies to interest paid in respect of a "bond, debenture, or similar obligation". But as noted above, clause 212(1)(b)(ii)(C) gives an exemption for interest payable on "bonds, debentures, notes, mortgages, hypothecary claims or similar obligations". The latter term is broader. As a result, we would expect that any interest payments made by XXXXXXXXXX that are not exempted from Part XIII tax by clause 212(1)(b)(ii)(C) would not come within paragraph 4(a) of Article XI.

We trust these comments will be of assistance.

Yours truly,

Jim Wilson
Section Manager
for Director
International and Trusts Division
Income Tax Rulings Directorate
Policy and Planning Branch