21 December 2005 External T.I. 2005-0154191E5 - Indexed debt obligation, excluded payment

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: Whether an "excluded payment" as defined in subsection 7001(7) of the Regulations would be considered to be interest on interest and qualify for a deduction under paragraph 20(1)(d) of the Income Tax Act

Position: Question of fact. Depends on whether it qualifies as "interest" and meets the criteria set out in the Miller court case.

Reasons: Definition of prescribed amount in paragraph 7001(1)(a) excludes "excluded payment" as interest receivable and received by a taxpayer in respect of an indexed debt obligation. Therefore, amount in question is not prescribed interest for purposes of subsection 16(6). Whether the amount would qualify as "interest" would depend on if the criteria as set out in the Miller case are met in a particular debt obligation.

2005-015419
XXXXXXXXXX G. Moore
(613) 957-8982
December 21, 2005

Dear XXXXXXXXXX:

Re: Subsection 7001(7) of the Income Tax Regulations

This is in response to your letter of October 11, 2005, inquiring about the deductibility of an "excluded payment" as defined in subsection 7001(7) of the Income Tax Regulations (the "Regulations").

Our Comments

The situation outlined in your letter appears to relate to a factual one, involving a specific taxpayer. It is not this Directorate's practice to comment on proposed transactions involving specific taxpayers other than in the form of an advanced income tax ruling. Although we cannot comment on your specific situation, we are prepared to provide the following general comments, which may be of assistance.

An indexed debt obligation, as defined in subsection 248(1) of the Income Tax Act (the "Act"), "means a debt obligation the terms or conditions of which provide for an adjustment to an amount payable in respect of the obligation for a period during which the obligation was outstanding that is determined by reference to a change in the purchasing power of money." Paragraph 16(6)(b) of the Act provides that where at any time in a taxation year, an indexed debt obligation is an obligation of a taxpayer, an amount determined in prescribed manner shall be deemed to be paid or payable in respect of the year by the taxpayer as interest in respect of the obligation and an amount determined in prescribed manner shall be deemed to be received and receivable by the taxpayer in the year as interest in respect of the obligation.

Section 7001 of the Regulations sets out the rules for the calculation of the prescribed amount for purposes of subsection 16(6) of the Act. Subsection 7001(1) is as follows:

"(1) For the purpose of subparagraph 16(6)(a)(i) of the Act, where at any time in a taxation year a taxpayer holds an interest in an indexed debt obligation, there is prescribed as interest receivable and received by the taxpayer in the year in respect of the obligation the total of

(a) the amount, if any, by which
(i) the total of all amounts each of which is the amount by which the amount payable in respect of the taxpayer's interest in an indexed payment under the obligation (other than a payment that is an excluded payment with respect to the taxpayer for the year) (emphasis added) has, because of a change in the purchasing power of money, increased over an inflation adjustment period of the obligation that ends in the year..."

Subsection 7001(7) of the Regulations defines an "excluded payment." Subsection 7001(3) of the Regulations provides for the determination of the amount that is to be treated as interest payable in respect of a taxation year of a taxpayer on an indexed debt obligation. The amount is equal to the amount that would be determined under paragraph 7001(1)(a) of the Regulations in respect of the taxpayer for the year if the taxpayer were the holder of the obligation and not the debtor in respect of the obligation.

Since an "excluded payment" is not included in the calculation of the amount under paragraph 7001(1)(a) of the Regulations, it is not prescribed as interest receivable and received by the taxpayer in the year in respect of the indexed debt obligation for purposes of subsection 16(6) of the Act.

The issue is whether an "excluded payment", by definition, is considered to be compound interest for purposes of paragraph 20(1)(d) of the Act. The term "interest" is not defined in the Act. Numerous cases, both tax and non-tax, assist in formulating the characteristics of interest. It is often defined as the return of or compensation for the use or retention of a sum of money owing to another person. It is payment for the time value of money.

Interest for tax purposes is generally accepted to mean an amount that has met three criteria as set out in the court case of Brenda J. Miller v. The Queen 85 DTC 5354 (FCTD). These criteria are that the amount:

(a) must be calculated on a day-to-day accrual basis;

(b) calculated on a principal sum; and

(c) must be compensation for use of the principal sum (or the right to the principal sum).

To be referable to a principal sum, amounts are usually determined by applying a percentage to that principal. In our view, an amount that is determined on the basis of other criteria (such as cash flow, revenue, or net profit) is not referable to a principal sum. While it is possible to create formulae under which amounts calculated on the basis of those other criteria are expressed as a percentage of the principal sum, the mere expression of such an amount in this manner does not necessarily qualify the amount as interest. Whether an "excluded amount" would be considered interest is a question of fact that would require a review of the documentation relating to a particular debt obligation.

We trust that these comments will be of assistance.

Yours truly,

Roberta Albert, CA
for Director
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate
Policy and Planning Branch