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:
(a) Deductibility of participating payments under the terms of a participating loan.
(b) Income inclusion of participating payments received by a lender.
Position:
(a) Briefly, our general position on participating payments where the facts support, inter alia, a finding that the loan exhibits the characteristics of debt and not equity and that the interest rate (including additional participating payments) on the loan does not exceed the prevailing market rates, is that the base interest payments and additional payments will generally be considered to be interest for the purposes of paragraph 20(1)(c).
(b) Generally, a Canadian lender/investor must recognize the amount as accrued or received pursuant to 12(1)(c), 12(3) or 12(4), as the case may be. Additionally, where the debt obligation is a prescribed debt obligation described in Regulation 7000(1), an amount determined in prescribed manner is deemed by virtue of 12(9) to accrue to the taxpayer as interest on the prescribed debt obligation.
Reasons:
(a) This position remains unchanged from that stated in response to Q. No.1 at the 1992 Corporate Management Tax Conference - Roundtable and in Income Tax Technical News No. 16 released on March 8, 1999.
(b) Operation of the Act.
XXXXXXXXXX 2004-010394
P. Diguer, CGA
February 8, 2005
Dear XXXXXXXXXX:
Re: Paragraph 20(1)(c) of the Income Tax Act (Canada) (the "Act")
We are writing in response to your letter dated November 16, 2004 in which you request our views on the deductibility of participation interest under the terms of a participating loan, as well as the timing of the interest deduction to the borrower and the timing of the income inclusion to the lender in these circumstances.
In particular you describe a situation where:
? A taxpayer (the "Borrower") borrows funds (the "Loan") on commercial terms from an arm's length lender (the "Lender"). Borrower uses the proceeds from the Loan in its business income producing activities.
? The Loan will have "Base Interest" and "Additional Interest".
? Base Interest will be payable by the Borrower in respect of each year that the Loan is outstanding, regardless of the cash flow of the Borrower. To the extent that Base Interest is not paid in a particular year, it will be capitalized and added to the principal amount of the Loan then outstanding.
? Additional Interest, subject to a maximum additional amount as described below, may also be payable in respect of each year that the Loan is outstanding, depending on the cash flow of the Borrower. The payment of Additional Interest is intended to increase the effective interest rate on the Loan to the prevailing market rate of interest for a loan with a similar risk profile, e.g. if the prevailing market rate was 12% and the Base Rate was 9%, the Additional Interest would be 3%.
? The amount of Additional Interest payable by the Borrower in respect of a taxation year will be limited to a maximum amount ("Maximum Additional Interest").
Maximum Additional Interest in respect of a year will be the amount of Additional Interest which, when added to:
(a) the total amount of Base Interest payable in respect of the Loan from the time the Loan was first advanced until the end of that year; and
(b) the total amount of Additional Interest payable in respect of all previous years,
equals the amount of interest that would have been payable on the Loan from the time the Loan was first advanced until the earlier of the end of that year or the date in that year that the Loan is repaid, if interest was computed at a rate equal to the arm's length commercial rate of interest on the total principal amount of the Loan that is outstanding from time to time.
You ask
(a) Would the amount of Base Interest payable each year by the Borrower be deductible by it as interest under paragraph 20(1)(c) of the Act in computing its income for that year, regardless of whether such amount of Base Interest is, in fact, paid in that year?
(b) In which year would the Lender be required to include Base Interest in its income in respect of a particular year?
(c) Would Additional Interest that becomes payable by the Borrower in respect of a particular year be deductible by it as interest under paragraph 20(1)(c) of the Act in computing its income for that year? As described above, Additional Interest will only become payable in respect of a particular year if the Borrower has Excess Cash available in that year.
(d) In which year would the Lender be required to include Additional Interest which has become payable by the Borrower in its income in respect of a particular year?
(e) Is it relevant that a Lender has an ownership interest in the Borrower?
(f) In determining the prevailing commercial arm's length interest rate applicable to a loan that is similar to the Loan, could consideration be given to the likelihood of payments of Additional Interest never being made by the Borrower (i.e. the likelihood that the Borrower would never have Excess Cash available)?
Your views
(a) The Base Interest payable by the Borrower in respect of a particular year would be deductible by the Borrower in that year as interest under paragraph 20(1)(c) of the Act, regardless of whether such amount is actually paid in the year.
(b) The Lender would be required to include the Base Interest in its income in the year in which such amount becomes receivable, even where such amount is not paid in the year.
(c) Additional Interest payable by the Borrower in respect of a particular year would be deductible by the Borrower in that year as interest under paragraph 20(1)(c) of the Act.
(d) The Lender would be required to include the Additional Interest in income in the year in which it becomes receivable.
Comments were not provided for either (e) or (f) above.
The situation that is described in your letter appears to relate to either a series of proposed or completed transactions involving specific taxpayers. As explained in Information Circular IC-70-6R5 dated May 17, 2002 ("IC-70-6R5") written confirmation of the tax implications inherent in particular transactions are given by this Directorate only where the transactions are proposed and are the subject matter of an advance ruling request submitted in the manner set out in IC-70-6R5. Where the particular transaction is completed, the inquiry should be addressed to the relevant Tax Services Office. Although we are unable to provide any opinion in respect of the specific transactions described in your letter, we have set out some general comments which we hope are of assistance to you. However, written opinions are not advance tax rulings and, accordingly are not binding on the Canada Revenue Agency.
(a) Deductibility of Base Interest
Provided that the Base Interest is paid in the year or payable in respect of the year pursuant to a legal obligation to pay periodic interest on the outstanding balance owing on the principal amount in respect of borrowed money used for the purpose of earning income from a business or property, and that all other relevant conditions in paragraph 20(1)(c) of the Act are met, the said Base Interest paid in the year or payable in respect of the year would, in our view, generally be deductible pursuant to subparagraph 20(1)(c)(i) of the Act.
(b) Income inclusion by Lender
Generally, a Canadian lender/investor entitled to receive interest on a debt obligation must recognize the amount as accrued or received pursuant to paragraph 12(1)(c) of the Act, or as accrued pursuant to subsection 12(3) of the Act [for a corporation, partnership or certain unit trusts] and 12(4) of the Act [for a taxpayer other than a taxpayer to which subsection 12(3) of the Act applies]. Additionally, where the taxpayer acquires an interest in a prescribed debt obligation described in any of Regulation 7000(1)(a) to (d) inclusively, an amount determined in prescribed manner is deemed by virtue of subsection 12(9) of the Act to accrue to the taxpayer as interest on the prescribed debt obligation.
(c) Deductibility of Additional Interest
Our general position on participating payments is to allow such amounts as interest deductions under paragraph 20(1)(c) of the Act where the payment satisfies all the conditions of the said paragraph and in addition the payment is limited to a stated percentage of the principal, the limited percentage reflects prevailing arm's-length commercial interest rates and no other facts indicate the presence of an equity investment. Where such evidence is not satisfied but other evidence indicates that participation payments are intended to increase the interest rate on the loan to prevailing market rates, the payments will also generally be considered to be interest for the purposes of paragraph 20(1)(c) of the Act. This position remains unchanged from that stated in response to question No.1 at the 1992 Corporate Management Tax Conference - Roundtable and in Income Tax Technical News No. 16 released on March 8, 1999.
(d) Income inclusion by Lender
See (b) above
(e) Lender owns an interest in the borrower
As indicated above, the Agency will generally consider a participation payment to be "interest" provided, inter alia, there are no facts that indicate the presence of an equity investment. In this regard, the Agency requires that there be no evidence that indicates that the participating payments are in reality a distribution of profit. This requirement applies to all participation payments under the terms of a participating loan arrangement and this includes a lending arrangement involving a Lender with an ownership interest in the Borrower.
The foregoing comments represent our general views with respect to the subject matter. As indicated in paragraph 22 of Information Circular 70-6R5, the above comments do not constitute an income tax ruling and accordingly are not binding on the Canada Customs and Revenue Agency.
Yours truly,
Steve Tevlin
for Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Planning Branch
All rights reserved. Permission is granted to electronically copy and to print in hard copy for internal use only. No part of this information may be reproduced, modified, transmitted or redistributed in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, or stored in a retrieval system for any purpose other than noted above (including sales), without prior written permission of Canada Revenue Agency, Ottawa, Ontario K1A 0L5
© Her Majesty the Queen in Right of Canada, 2005
Tous droits réservés. Il est permis de copier sous forme électronique ou d'imprimer pour un usage interne seulement. Toutefois, il est interdit de reproduire, de modifier, de transmettre ou de redistributer de l'information, sous quelque forme ou par quelque moyen que ce soit, de facon électronique, méchanique, photocopies ou autre, ou par stockage dans des systèmes d'extraction ou pour tout usage autre que ceux susmentionnés (incluant pour fin commerciale), sans l'autorisation écrite préalable de l'Agence du revenu du Canada, Ottawa, Ontario K1A 0L5.
© Sa Majesté la Reine du Chef du Canada, 2005
Email this Content