19 January 2006 Internal T.I. 2005-0130461I7 - Meaning of "Paid or Payable"

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: In subparagraph 95(2)(a)(ii) of the Income Tax Act, does the term "payable" refer to an amount accrued during the period, or to an amount for which there is an immediate legal obligation to pay, but has not yet been paid?

Position: "Payable" refers to amounts accruing during the relevant period.

Reasons: It is the interpretation that best fits the context and policy of the provision.

      							January 19, 2006

International Tax Operations Division		Ted Cook
International Tax Directorate
5th Floor, 344 Slater Street
Ottawa ON  K1A 0L5
Attention:  Mark Turnbull

								2005-013046

Paid or Payable

We are providing this memorandum as a follow up to our discussions with respect to the meaning of the term "payable" as used in subparagraph 95(2)(a)(ii) of the Income Tax Act (the "Act").

Facts

In our discussions we considered a hypothetical example along the following lines. A corporation that is not a resident of Canada for purposes of the Act ("FA") is a foreign affiliate of a corporation resident in Canada ("Canco"). A corporation that is not a resident of Canada and that is not a foreign affiliate of Canco ("Forco") issues a bond with a 5-year term to FA on September 1 of Year 1. Interest accrues daily and is calculated at a market rate. Interest payments are made semi-annually - on September 1 and March 1. Forco makes the first interest payment on March 1 of Year 2 and the second interest payment on September 1 of Year 2. Canco, FA and Forco all use the calendar year as their taxation year. Both FA and Canco are related to Forco for purposes of the Act. Absent the application of paragraph 95(2)(a) of the Act, interest on the bond is "income from property" to FA for foreign accrual property income ("FAPI") purposes.

Issue

Paragraph 95(2)(a) of the Act provides that certain amounts that would otherwise be income from property of a foreign affiliate (e.g., the bond interest in the example above) shall instead be included its income from an active business for FAPI and surplus computation purposes. Subsection 95(2) states in part:

95(2) Determination of certain components of foreign accrual property income - For the purposes of this subdivision,

(a) in computing the income from an active business for a taxation year of a particular foreign affiliate of a taxpayer in respect of which the taxpayer has a qualifying interest throughout the year there shall be included any income of the affiliate for that year from sources in a country other than Canada that would otherwise be income from property of the affiliate for the year to the extent that

(i) ... ,
(ii) the income is derived from amounts that were paid or payable, directly or indirectly, to the particular affiliate or a partnership of which the particular affiliate was a member

(A) by

(I) ..., or
(II) ...

to the extent that those amounts that were paid or payable are for expenditures that would, if the non-resident corporation or the partnership were a foreign affiliate of the taxpayer, be deductible by it in the year or a subsequent year in computing the amounts prescribed to be its earnings or loss from an active business, other than an active business carried on in Canada, ...

[emphasis added]

The specific issue at hand is the meaning of the term "payable" as used in the preamble and all the clauses of subparagraph 95(2)(a)(ii). There are two main competing interpretations of the term "payable" in this context:

i) payable could refer to amounts that are accrued during the year; or

ii) payable could be limited to those amounts for which there is an immediate legal obligation to pay, but for which the actual payment has not yet been made (there is a third alternative which is also discussed below).

Put in the context of the example above, the issue is whether the interest accruing from September 1 to December 31 of Year 1 but that is not due and paid until March 1 of Year 2 would be "payable" in Year 1 for purposes of subparagraph 95(2)(a)(ii)? If "payable" refers to amounts accruing throughout the year, the accrued interest from September 1 to December 31 of Year 1 could be included in FA's income from an active business for Year 1; but if payable instead refers to amounts for which there is an immediate legal obligation to pay but for which the actual payment has not been paid, no amount in respect of the interest relating to September 1 to December 31 of Year 1 could be included in FA's income from an active business for Year 1 because there is no immediate legal obligation to pay until March 1 of Year 2.

Analysis

The Provision

Parsing subparagraph 95(2)(a)(ii), there are a number of conditions that need to be met before the interest on the bond will be included in FA's income from an active business. Those relevant to the example above are:

1. the provision applies to what would otherwise be income from property for the year. So, the interest on the bond would otherwise be included in FA's income from property for the year;

2. the income must be derived from amounts that were "paid or payable" to FA. That is, the interest on the bond must be "paid or payable" to FA;

3. those amounts paid or payable (i.e., the interest on the bond) to FA are for expenditures of Forco; and

4. if Forco were a foreign affiliate, those amounts paid or payable would be deductible "by it in the year or in a subsequent year" in computing prescribed earnings or loss from an active business.

With respect to the first condition, FA must calculate its FAPI in accordance with the provisions of the Act (i.e., not in accordance with any foreign tax or commercial law), and the interest from the bond would be included in income on an accrual basis, rather than on a paid basis, pursuant to subsection 12(3) of the Act. As a result, for Year 1, Canco's income from the bond would be the interest accruing from September 1 to December 31 of Year 1. For Year 2, Canco's income from the bond would be the interest accruing from January 1 to December 31 of Year 2.

The second condition - the meaning of "paid or payable" - will be discussed in detail below.

With respect to the third condition, it is clear from the facts above that any interest will ultimately be an expenditure of Forco.

With respect to the fourth condition, we note that the term "earnings" is prescribed and the relevant definition is found in subsection 5907(1) of the Income Tax Regulations. A corporation's earnings in respect of an active business carried on in a country includes the income from that active business computed for foreign income tax purposes (either on a residency or source basis, depending on the circumstances). If no such computation is required under the relevant foreign tax law, the income from that active business is to be computed in accordance with Part I of the Act.

This has implications for the operation of subparagraph 95(2)(a). Paragraph 20(1)(c) of the Act allows a deduction in computing income for:

an amount paid in the year or payable in respect of the year (depending on the method regularly followed by the taxpayer in computing the taxpayer's income), pursuant to a legal obligation to pay interest ...

It is generally accepted that this provision requires taxpayers to deduct interest expense on either a cash or accrual basis depending on the taxpayer's usual practice (see paragraph 5 of Interpretation Bulletin IT-533, Interest Deductibility and Related Issues). This almost invariably means that a corporation takes its interest deductions on an accrual basis. So in the example above, if Forco were required to compute its income in accordance with Part I, in computing its income for Year 1 it would deduct the interest accrued from September 1 to December 31 even though the interest would not be due and paid until March 1 of Year 2. Then in computing its income for Year 2, it would deduct the interest accruing from January 1 to December 31 of Year 2, not the interest payments actually made on September 1 and March 1 of Year 2.

But to meet the requirements of subparagraph 95(2)(a)(ii), the expenditures have to be deductible by Forco in the same year that it is included in the foreign affiliate's income or in a subsequent year. This means that with respect to interest included in FA's income in Year 1, the amount paid or payable could be deductible in any of Years 1, 2, 3, 4, 5 or 6 for Forco. But with respect to interest included in FA's income in Year 2, the amount paid or payable would have to have been deductible in any of Years 2, 3, 4, 5 or 6. If the deduction for Forco arose in Year 1, it would not fit into the provision.

If an accrual approach to the meaning of "payable" in subparagraph 95(2)(a)(ii) is taken, the provision hangs together:

• Interest from the bond would be included in income on an accrual basis (e.g., the interest that accrued from September 1 to December 31 of Year 1 would be included in FA's income for Year 1).
• All of the interest included in FA's income for Year 1 would be "payable" to FA for purposes of subparagraph 95(2)(a)(ii).
• The accrued interest would have been for an expenditure of Forco.
• If Forco were a foreign affiliate, the accrued interest on the bond from September 1 to December 31 of Year 1 would have been deductible in calculating Forco's earnings for Year 1.

Since the income inclusion for FA and the deduction for Forco are both on an accrual basis, using an accrual approach to "payable" allows the deductions and inclusions to be symmetrical.

But if "payable" instead means an immediate legal obligation to pay, but which has not yet been paid, the following results arise:

• Interest from the bond would be included in income on an accrual basis (e.g., the interest that accrued from September 1 to December 31 of Year 1 would be included in FA's income for Year 1).
• None of the interest included in FA's income for Year 1 would be "payable" to FA for purposes of subparagraph 95(2)(a)(ii) since no immediate legal obligation to pay arises until March 1 of Year 2. As a consequence, the interest accruing from September 1 to December 31 of Year 1 would be payable in Year 2.
• The accrued interest would have been for an expenditure of Forco.
• If Forco were a foreign affiliate, the accrued interest on the bond from September 1 to December 31 of Year 1 would have been deductible in calculating Forco's earnings for Year 1. That accrued interest would not be deductible in calculating its earnings in Year 2 (see paragraph 6 of IT-533 and M.N.R. v. Mid-West Abrasive Company of Canada, 73 D.T.C. 5429 (F.C.T.D.)).

Since the interest accruing from September 1 to December 31 of Year 1 only becomes paid or payable to FA in Year 2, the interest must be deductible in calculating Forco's earnings in Year 2 or a later year in order to satisfy the requirement that the interest be deductible "by it in the year or in a subsequent year". But by virtue of paragraph 20(1)(c), the interest would be deductible by Forco in Year 1, not Year 2 or a later year. Therefore, subparagraph 95(2)(a)(ii) would not apply to interest accruing from September 1 to December 31 of Year 1.

The same logic would apply to later years as well. For example, for Year 3 FA would include in its income all interest accrued from January 1 to December 31 of Year 3. Its income would not be based on the actual interest payments made on March 1 and September 1 of Year 3. But again, for purposes of calculating its FAPI for Year 3, the amounts paid or payable to FA would not include the accrued interest from September 1 to December 31 of Year 3 because it does not become payable until Year 4. But if Forco were required to calculate its income in accordance with Part I, that accrued interest would have been deductible in calculating its Year 3 tax liability, not its Year 4 tax liability.

Consequently, it appears that unless there is an interest payment date of December 31, the accrued portion of the interest would not be eligible each year. We are not aware of any tax policy reason that would support this as an intended result.

We have also considered a third alternative with respect the to meaning of "payable". As noted above, one of the requirements for the application of subparagraph 95(2)(a)(ii) is that if Forco were a foreign affiliate, those amounts paid or payable would be deductible "by it in the year or in a subsequent year" in computing prescribed earnings or loss from an active business - so there is a specific rule as to when the amounts must be deductible. Arguably the provision is silent as to when amounts must satisfy the quality of being "paid or payable" - for example, the preamble of subparagraph 95(2)(a)(ii) just states: "the income is derived from amounts that were paid or payable, directly or indirectly, to the particular affiliate ..." with no further qualification. This raises the possibility that even if an amount becomes "payable" in a year subsequent to when it is included in income and would have been deductible, it still satisfies the requirements of subparagraph 95(2)(a)(ii). This approach focuses on timing, rather than on the definition of payable per se.

If this interpretation is correct, an amount could initially be included in FAPI and then be transformed into income from an active business in a later year when the amount became paid or payable. So, in the hypothetical example set out above, interest that accrued in Year 1 (but that was not paid or payable until Year 2) would be included in FAPI in Year 1, but then in Year 2 when the interest was paid the amount included in FAPI in Year 1 would be transformed into income from an active business for Year 1.

There are difficulties with this approach. Firstly, as will be mentioned below, "paid or payable" appears to be a reference back to "income from property for the year". Secondly, why would it be necessary to refer to both paid and payable if we could wait till the end of the day to see whether an amount was ultimately paid or not? Thirdly, this interpretation would seem to systematically require the amendment of prior year returns. And finally we understand that applying this interpretation to the live situation you are considering would still cause some exempt surplus to evaporate for the corporate group. As previously mentioned, we are not aware of any tax policy reason for subparagraph 95(2)(a)(ii) not to apply as a result of timing issues.

Other Provisions

The term "payable" is used in a number of different contexts in the Act, including:

• paragraph 20(1)(c) - "payable in respect of the year";
• paragraph 18(3)(b) - "payable in the year";
• subsection 83(2) - "Where at any particular time ... a dividend becomes payable";
• paragraph (a)(i) of the definition of "outstanding debts to specified non-residents" in subsection 18(5) - "that was payable by the corporation";
• subsection 104(6) - "became payable in the year"; and
• subparagraph 40(1)(a)(iii) - "proceeds of disposition of the property that are payable to the taxpayer after the end of the year".

Subsection 104(24) defines "payable" for purposes of subsection 104(6) and some other provisions. It deems amounts not to have become payable to a beneficiary unless the beneficiary was entitled in the year to enforce payment of the amount. This provides a statutory rule that for purposes of certain provisions the term "payable" refers to an immediate legal obligation to pay, but the payment has not yet been made. It could be suggested that without the provision, an amount might be payable even if there is no immediate legal obligation to pay. Alternatively, subsection 104(24) may just provide greater certainty.

The meaning of the term "payable" has been considered in a number of court cases, but the cases do not provide a consistent meaning of the term for all purposes of the Act. The two root cases are John Colford Contracting Co. Ltd. v. M.N.R., 60 D.T.C. 1131 (Ex. Ct.), aff'd 62 D.T.C. 1338 (S.C.C.) and J. L. Guay Ltee v. M.N.R., 71 D.T.C. 5423 (F.C.T.D.), aff'd 73 D.T.C. 5373 (F.C.A.), aff'd 75 D.T.C. 5094 (S.C.C.). Colford is actually a decision dealing with the meaning of "receivable" and in it the Court held that receivables must be amounts which "the intended recipient has a clearly legal, though not necessarily immediate, right to receive". And J. L. Guay is generally seen as taking the reasoning in Colford and applying it to the term "payable" (however this is not necessarily the ratio of the case since the amounts "payable" were ultimately held to be contingent in nature).

Perhaps the leading case is Mid-West Abrasive Company. In that case, the Federal Court-Trial Division considered the predecessor to paragraph 20(1)(c). Both paragraph 20(1)(c) and its predecessor (subsection 11(1)) provide for the deduction of interest expenses based on the "amount paid in the year or payable in respect of the year (depending on the method regularly followed by the taxpayer in computing the taxpayer's income)". The Federal Court-Trial Division held that:

In my opinion the words "paid in the year" are applicable to those taxpayers who, in computing income, regularly follow the cash basis accounting method and the words "payable in respect of the year" are applicable to those who, in computing income, regularly follow the accrual accounting method.

This is generally accepted as the correct interpretation of paragraph 20(1)(c) and is reflected in the position taken by the Canada Revenue Agency ("CRA") in paragraph 5 of IT-533. Consequently, at least where payable is used in conjunction with "in respect of the year", it should likely be taken to mean an amount calculated on an accrual basis.

In The Bank of Nova Scotia v. The Queen, 80 D.T.C. 6009 (F.C.T.D.), aff'd 81 D.T.C. 5115 (F.C.A.), the Trial Division considered the term "tax payable" in Article 21 of the Canada-United Kingdom Tax Agreement. In this case, the Court referred to a dictionary meaning of the term and held that:

Kohler's Dictionary for Accountants, 5th ed. defines "payable" as follows: "adj. Unpaid whether or not due. n. A Liability; a debt owing to another; an account or note payable". Normally, for an amount to be payable there must be a clear legal though not necessarily immediate obligation to pay it. (Refer Minister of National Revenue v. John Colford Contracting Company Limited (60 DTC 1131 at 1134 and 1135) as to the similar comment relating to the word "receivable").

A year later, in Timagami Financial Services Ltd. v. The Queen, 81 D.T.C. 5064 (F.C.T.D.), aff'd 82 D.T.C. 6268 (F.C.A.), the Federal Court-Trial Division considered the meaning of the term "... an amount has become payable to a taxpayer in a taxation year ..." in the context of then subsection 14(1) of the Act. A taxpayer entered into a contract to sell his business in 1975 and was to be paid in a number of instalments over four years. The question before the Court was whether the entire amount to be paid pursuant to the contract was payable in 1975 for purposes of subsection 14(1). The Trial Division referred to different dictionaries than had been used in Bank of Nova Scotia and found that the "word 'payable' in subsection 14(1) is synonymous with due, a present obligation to pay" and accordingly found that the instalments only became payable when payment was actually due. The Federal Court of Appeal dismissed the Crown's appeal and opined that:

In subsection 14(1), the words "payable to" are used without any indication in the subsection that they are to be read in an extended way or in a technical sense: the subsection leaves the disputed words to be read in their ordinary, everyday way.

This is a reference back to the meaning of "payable" relied upon by the Trial Division.

Proposed Approach

Given the two different meanings given to "payable" by the courts, perhaps an appropriate working definition is that quoted in Aceti v. M.N.R., 92 D.T.C. 1893 (T.C.C.):

Capable of being paid; suitable to be paid; admitting or demanding payment; justly due; legally enforceable. A sum of money is said to be payable when a person is under an obligation to pay it. Payable may therefore signify an obligation to pay at a future time, but, when used without qualification, term normally means that the debt is payable at once, as opposed to "owing".

(Black's Law Dictionary, 6th Edition, 1990, at page 1128)

Essentially this takes the view that "payable" is capable of two potential meanings, and which is appropriate will depend on the context of the particular provision. In Mid-West Abrasive Company, the Court looked to the surrounding words and stated: "... 'In respect of the year' refers, in my opinion, to the year during which the borrowed money was used and not the year in which the lender chose to make the request for interest...".

The CRA also has been willing to ascribe different meanings to the term "payable" depending on the context of its usage within the Act. As noted above, at paragraph 5 of IT-533, the CRA takes its cue from Mid-West Abrasive Company in interpreting paragraph 20(1)(c). In contrast, at paragraph 2 of Interpretation Bulletin IT-66R6, Capital dividends the CRA takes the view that for purposes of subsection 83(2), a dividend becomes payable on the day stipulated by the resolution of the directors declaring the dividend (i.e., on the day the immediate obligation comes into existence).

With respect to subparagraph 95(2)(a)(ii), the term "payable" is used as part of "paid or payable". There is there is no other direct qualifier such as "in the year" or "in respect of the year", but "paid or payable" is a reference back to "income from property of the affiliate for the year". Consequently, it should be interpreted, if possible, in a manner consistent the calculation of the income of the affiliate for the year - particularly where the alternative interpretation would create a lacuna in the legislation. This strongly implies the accrual approach is the correct one.

Conclusion

It is our view that the term "payable" is generally used in the Act as a reference to either amounts calculated on an accrual basis or amounts for which there is an immediate legal obligation to pay, depending on the context (see also the third alternative discussed above). Based on the context of subparagraph 95(2)(a)(ii) and the implications of the possible interpretations, it is our view that the term "payable" with respect to debt obligations covered by subparagraph 95(2)(a)(ii) means amounts calculated on an accrual basis for the taxation year under consideration. If you have any questions regarding this memorandum, please do not hesitate to contact Ted Cook at (613) 946-4165.

Olli Laurikainen, C.A.

Manager
For Director
International and Trusts Division
Income Tax Rulings Directorate