15 August 2005 External T.I. 2005-0132881E5 - Reserve Account

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: Financing Arrangement - prepayments

Position: Appears acceptable but should be dealt with a Ruling.

Reasons: No compulsion to repay

							2005-013288
XXXXXXXXXX 						C. Tremblay, CMA
(613) 957-2139
August 15, 2005

Dear XXXXXXXXXX:

Re: Withholding Tax Exemption under subparagraph 212(1)(b)(vii) of the Income Tax Act (the "Act")

We are writing in response to your letters of May 19 and June 21 and our phone conversations (XXXXXXXXXX/Tremblay) of July 25 and August 5, 2005 wherein you requested our interpretation as to whether certain repayment terms of notes issued by a resident corporate borrower would comply with the exemption for Part XIII withholding tax under subparagraph 212 (1)(b)(vii) of the Act. In general, you describe a reserve account and certain optional repayment terms as follows:

1. Redemption Account

Excess cash generally will be deposited into a "Redemption Account" invested in government debt securities until used as set forth below.

2. Option Prepayment After Three Years

The borrower may use funds in the Redemption Account to optionally prepay the notes after the third anniversary of the issuance of the notes. Such prepayment would be subject to a prepayment penalty of between 2% to 3% from the third and fifth anniversary of the issuance of the notes.

The borrower may also use certain funds in the Redemption Account to make a capital investment in respect of the project on the following conditions:

(a) the borrower creates a budget and projections showing projected internal rate of return in excess of the average interest rate then applicable to the notes examined by an independent advisor and deemed to be reasonable;

(b) the borrower contributes cash in the form of additional equity contributions equal to at least 25% of the costs set forth in the budget (e.g., if there is a decision to reinvest in the project and the budget is $1 million for such reinvestment, the borrower must invest an additional $250,000, and the borrower will be entitled to withdraw $750,000 from the Redemption Account for such reinvestment into the project); and

(c) when funds are withdrawn from the Redemption Account to make a capital expenditure, the borrower will pay to the noteholders a fee that is 25 basis points less than the prepayment penalty (noted above) for the applicable year in which the withdrawal occurs.

Our Comments:

The situation that is described appears to involve a series of actual proposed transactions. It is not our practice to give written opinions concerning proposed transactions, as indicated in Information Circular 70-6R2. 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 may be of some assistance.

It is a question of fact whether under the terms of the obligation or any agreement relating thereto, the borrower corporation may under any circumstances be obliged to pay more than 25% of the principal amount thereof within 5 years from the date of issue. In our view, where a borrower is required to place an amount in a specific reserve account, the borrower may have an obligation to pay more than 25% of the principal amount within a 5 year period. Our concern is that at a certain point, for example, the interest rate on the reserve account may be less than the interest rate on the loan, and the borrower will be economically compelled to repay the loan. However, it is our opinion that in a situation where the borrower is not required to repay the notes and is under no economic compulsion to repay the notes, optional repayment terms such as described above where the purpose is to use the reserve account funds in the business, the terms would not, in and by themselves, amount to an obligation to repay more than 25% of the principal amount of the notes within five years from their issuance as required under subparagraph 212(l)(b)(vii) of the Act.

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 CRA. Our practice is to make this specific disclaimer in all instances in which we provide an opinion.

Yours truly,

Steve Tevlin
for Director
Financial Sector and exempt Entities Division
Income Tax Rulings Directorate