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Principal Issues: [TaxInterpretations translation] Does the interest that is added to the principal of the debt under paragraph 3 of the note payable constitute a loan by the taxpayer or is it compound interest?
Reasons: There was no tradition of money in respect of that interest. It cannot be concluded that the interest calculated on the capitalized interest is deductible under paragraph 20(1)(c).
April 21, 2008
L'Est du Québec Tax Service Office Headquarters
Large Business Audit Division Income Tax Rulings Directorate
Attention: Ms. Stéphanie Garneau Michel Lambert, CA, M.Fisc.
This is in response to your memorandum of September 7, 2007 concerning the above taxpayer.
Unless otherwise indicated, all statutory references herein are to provisions of the Income Tax Act (the "Act").
Name of the parties
XXXXXXXXXX The Vendor
XXXXXXXXXX The Taxpayer
1. On XXXXXXXXXX, the Vendor sold to the Taxpayer its assets in consideration for shares of the Taxpayer and a debt of $XXXXXXXXXX bearing interest at an annual rate of XXXXXXXXXX%. This debt is evidenced by a note payable.
2. The note provides in the third paragraph that interest may be added to the principal of the debt. It states:
3. The Taxpayer did not pay the interest at the end of each year and the provisions of the preceding paragraph applied. Since the Vendor is a non-resident and the Taxpayer considers that it has paid the accrued and capitalized interest each year, it has withheld pursuant to paragraph 212(1)(b) and added the interest, net of withholding tax, to the balance of its debt.
4. You asked whether the interest payable at the end of the second year on the interest that was not paid to the creditor in the first year is deductible.
5. You are of the opinion that this interest is compound interest that may be deducted from the Taxpayer's income pursuant to paragraph 20(1)(d) in the year it is paid.
6. The Taxpayer's representative is of the view that interest was paid at the end of each year under the above paragraph and that the interest may be deducted pursuant to paragraph 20(1)(c) without specifying the subparagraph. In support of this opinion, the Taxpayer's representative invokes the fact that the carrying value of the debt is increasing on the Taxpayer's books. The representative is of the view that if it were a matter of compound interest, the carrying value (on the books) could not be increased. The representative claims that it is simple interest on a second debt and that this debt is a loan. Frederick W. Hill. V. Her Majesty the Queen, 2002 DTC 174 is also invoked.
7. In our view, it must first be established whether the interest added to the principal of the debt under paragraph 3 of the note payable constitutes a borrowing in itself on the part of the Taxpayer. To conclude that there is a loan in civil law, we will see that there must be a payment of money.
If it is not a loan per se, the question becomes whether the addition of interest to the original loan results in a new debt in the amount of the original debt plus interest. That could be a novation by change of debt.
In both cases, the interest could be deducted from the Taxpayer's income under paragraph 20(1)(c) if all its conditions for application are satisfied.
If the interest does not constitute a loan, the interest could be deducted from the taxpayer's income under paragraph 20(1)(d) where all its conditions for application are satisfied.
Finally, it will be necessary to determine whether Part XIII tax was payable and whether withholding was necessary.
Analysis of tradition of money
8. Article 2314 of the Civil Code of Quebec (CCQ) defines a simple loan as follows:
"A simple loan is a contract by which the lender hands over a certain quantity of money or other property that is consumed by use to the borrower, who binds himself to return a like quantity of the same kind and quality to the lender after a certain time."
In civil law, in order to be in the presence of a loan of money, it must be possible to establish that there was a tradition of amounts of money between the debtor and the creditor. In Crédit Bail Banque Nationale Inc. v. Le sous-ministre du revenu du Québec,  R.D.F.Q. 10, Lachapelle J. of the Court of Québec, referring to previous decisions, made the following comment: [TaxInterpretations translation]
In Marcelon, Poirier J. analyzed the French case law and doctrine and, relying on the Supreme Court's McCool decision, concluded, as did Adolphe Prévost J., that the tradition of a sum of money is an essential condition of a loan contract.
The Court of Appeal in National Bank of Canada v. Deputy Minister of Revenue of Quebec,  R.D.F.Q. 124 recognized the importance of tradition: [TaxInterpretations translation]
Furthermore, the sums involved cannot constitute a loan, as the essential condition of the tradition of a sum between the lender and the borrower is absent in this case.
9. The courts have been called upon on several occasions to rule on the meaning of the tradition of money in civil law. The Quebec Court recently summarized the rules applicable to the tradition of money in Imperial Tobacco Canada v. Quebec (Sous-ministre du Revenu)  J.Q. no.9254. The court referred to Simoneau v. Roy, 1965 R. L. 193. We note the following passage: [TaxInterpretations translation]
"In Simoneau v. Roy, the Superior Court had to rule on what constitutes a "tradition" within the meaning of the Civil Code of Québec. In that case, the applicant was a creditor of the balance of the sale price of $7,000 for the purchase of animals, farm implements and other items. He gave a full and final release of this amount to his debtor and consequently effectively remitted to the latter the $7,000 that the latter no longer owed him. At the same time, in a concomitant deed, the debtor acknowledged having borrowed the sum of $7,000 from the applicant. He had therefore just received such $7,000 by receiving a receipt for the sale price of what he had bought in cash and owed. The respondent argued that there had been no tradition because the borrower had not received any money at that time and therefore there could not be a loan within the meaning of the civil law. The Superior Court, seized of this situation, decided that the tradition was effective... :
In this loan, as in any other, it is always necessary to deliver the object of the loan. However, must this delivery be manual and made at the same time as the act recording the parties' intention? The answer to this question is obviously no. Delivery of the subject-matter of the loan may have been made earlier. It may exist in various forms. All that matters is that it is effective.
In the course of commercial transactions, the legal institution of lending has acquired considerable popularity and extremely subtle procedures. Everyone knows that considerable sums of money are lent in all its forms without anyone seeing it. Simple entries in the books, most of the time, are sufficient to establish the transfer of funds.
In the R-5 deed, he gives a full and final release of this amount and, consequently, effectively remits to the debtor the sum of $7,000 that the latter no longer owes him. At the same time, in a concomitant deed, the debtor acknowledges having borrowed the same $7,000 from the applicant. It is palpable that he has just received this sum, by receiving a receipt for the sale price of what he bought in cash and owed.
In that decision, the court accepted the book entries as evidence of the money transfers. However, the bookkeeping entries did not create the money tradition. In our view, the court found the tradition of money by the overall actions of the parties, including the granting of the release and the granting of a new loan. In the case under review, the parties did not take actions similar to those in Simoneau and we are of the view that that decision can be distinguished from the present case.
10. The Quebec Court of Appeal in Le groupe C.S.L. Inc. v. le sous-ministre du revenu du Québec, 500-09-010963-015, indicated that the tradition of money could be made by appropriate accounting entries. In that case, the appellant had acquired assets from its parent corporation in consideration for two debts payable which were recognized by the issuance of two notes. The appellant claimed that the notes were back-to-back loans between it and its parent corporation.
At paragraph 39, Dussault J. on behalf of the court commented as follows:
I tend to agree with the appellant who writes in her factum as follows:
The trial judge also erred in ignoring the jurisprudence pleaded before him with respect to the principle of the "effective transmission" of a sum of money under a loan agreement and in refusing to admit that a transmission, without being physical or direct, can be effected by simple accounting entries or book entries, particularly when the transactions in question are between closely related persons who have a common bank account.
After considering all the relevant facts, the court concluded that the intention of the appellant and its parent company was to create a lender-borrower relationship and that the tradition of money was made through proper accounting entries. The actions of the taxpayers are important in establishing whether there is a loan between the parties. The court specifically stated that in the following terms:
"The Deputy Minister argues that it is not enough for the taxpayer to have intent, but that he must have done so. I do not disagree with this statement, but in this case there is undisputed evidence and documents that actually demonstrate the existence of a loan. "
11. Thus, we note that the courts seem ready to accept that, in certain cases, an effective tradition of sums recorded by accounting entries may be sufficient to be able to conclude that a loan of money has been made. On the other hand, it is necessary to be able to demonstrate the intention to make a loan of money and this intention must be accompanied by actions that confirm the actual transfer of the sums of money.
12. In the situation under consideration, the Taxpayer and the Vendor may have intended to enter into a loan of money by accepting the third paragraph of the note. However, no facts were submitted to us to show that there was an actual transfer of the money. The mere statement that an amount of interest was added to the principal of the original debt does not seem to us sufficient to conclude that there was a tradition of money and a loan between the parties.
Analysis on novation
13. In Les obligations, published by Éditions Yvon Blais, Professor Jean-Louis Beaudoin and his colleagues state the following: [TaxInterpretations translation]
"Novation by change of debt occurs where, between the same persons, a new debt with a new element is substituted for the old one (article 1660, paragraph 1 CcQ). The same debtor thus undertakes a commitment to the same creditor, but assumes a new obligation (and not just a modified obligation) while being discharged from the old one."
Moreover, article 1661 provides that novation is not presumed; the intention to effect it must be evident.
14. In Frorian Inc. v. Deputy Minister of Quebec,  R.D.F.Q. 24, the Court of Quebec considered the issue of novation in the context of a declaration of dividend. In that case, G. & R. De la Fontaine declared a dividend on December 17, 1984. On December 31 of the same year, G. & R. De la Fontaine signed a document in favour of the applicant that read as follows: [TaxInterpretations translation]
On demand, we promise to pay to "Frorian Inc. the sum of six hundred and thirty-two thousand dollars ($632,000.00) without interest and without any specified method of repayment for the loan of the said sum made this day.
The question was to establish if that promise had the effect of novating the debt resulting from the declaration of dividend.
The court concluded that there had been a novation because the obligation to pay a dividend had been extinguished while a new obligation, namely a promise to pay, had been created. Furthermore, the books of account of both parties recognized that fact.
15. In the case under consideration, the conduct of the parties does not lead us to conclude that they intended to novate. Furthermore, in our view, the mere addition of unpaid interest to an existing debt does not have the effect of terminating the existing obligation and creating a new one. Thus, we are of the opinion that there has been no novation by change of debt in this case.
The Hill case
16. The Taxpayer believes that its situation is similar to that described in Frederick W. Hill v. Her Majesty the Queen, 2000-3636-IT-G, 2002 DTC 1749 (TCC). In that decision, the judge had to determine, inter alia, whether certain transactions pursuant to a clause in a mortgage agreement constituted a payment of interest and a borrowing of an equal amount as principal, with the result that the excess interest was not compound interest but simple interest. The starting point for the Court's analysis was the following wording of the mortgage agreement between the parties, which the judge quoted in paragraph 30 of the judgment:
“2. The Mortgagor shall pay to the Mortgagee the Interest Payment on each Payment Date during the Term, Provided However, if the Interest Expense on any Payment Date exceeds the Balance of Net Cash Flow Payable to the Mortgagee, then the amount of said excess shall accrue due and be payable to the Mortgagee on the 31st day of December in each year. Up to and including the year 1994, upon payment by the Mortgagor of any excess as aforesaid, Mortgagor may request in writing from the Mortgagee an advance of such excess. Mortgagee shall, within thirty (30) days of such request, advance to the Mortgagor the amount of such excess requested by Mortgagor, provided that the Principal of the Mortgage shall never exceed Thirty Five Million Dollars ($35,000,000).
3. Subject to paragraph 2 above, if the mortgagor does not pay the mortgagee the excess of the interest expense on any payment date over the balance of the net cash flow, such excess shall be added to the balance of the principal and shall bear interest at the rate stipulated in this schedule at the relevant period.”
In the judge's view, the wording of those two paragraphs would have allowed the mortgagee to sue on 31 December of each year to recover the excess interest. In paragraph 32 of the decision, he concludes as follows:
“[…] the parties remained bound to an agreement that in clear terms gave the mortgagee the right to seek the excess interest every December 31.”
In the situation under review, the creditor did not request the payment of interest within the time limit. Consequently, the interest was not due as it was in the Hill decision.
17. Furthermore, in Hill, the judge was satisfied that the parties had ensured that the necessary funds were available for what the parties referred to as the cheque exchange. He commented at paragraph 50 of the decision that:
However, the cheque exchange before me is distinguishable as both the Appellant and Postel had arranged for sufficient funds such that the cheques (wire transfers) would indeed be honoured, and in fact were honoured. There were readily identifiable funds of $60,000,000 from each side of the transaction: it was not a matter of each side relying on the other side's funds for their cheques to be honoured. If the conditions were met, that is, if you have your money ready and I have mine ready, the exchange is completed. This is quite different from parties recognizing that neither side really needs to have any money ready for an exchange.
18. In the present case, there is nothing to suggest that the Taxpayer and the Vendor acted in a manner similar to the parties in Hill. In particular, there is no evidence that there was any money available to establish a loan of money.
Part XIII tax
19. The situation under review is more similar to Quebec Cartier Mining Company v. Minister of National Revenue, 84 DTC 1348. In that case, the taxpayer had borrowed money from its American parent corporation. Instead of paying interest on the scheduled basis, the taxpayer elected under a clause in the loan agreement to capitalize the interest on the principal of the debt. The clause in question read as follows:
"Interest shall be payable on April 1, 1972 and semi-annually on each October 1 and April 1 thereafter. At the option of QCM, QCM may elect on ten (10) days' prior written notice given by it to USS, that interest due on any one or more of these dates shall be added to the principal amount borrowed hereunder, in which event such interest shall not be due and payable on said date but rather shall be thereafter considered part of the unpaid principal amount borrowed hereunder."
At issue was the application of paragraph 212(1)(b), namely whether the taxpayer had paid or credited an amount to its parent as, or on account or in lieu of payment of, interest. The court concluded that the interest so capitalized had not been paid or credited to the creditor. The judge stated:
"The words "as, on account of or in lieu of payment of, or in satisfaction of ... interest" taken together with the word "credits" seem to me to confirm that the word "credit" make available to, must be given the meaning “make available to” [sic]
“Replacing a debt of interest" by an acknowledgement of debt as, on account or in lieu of payment of, or in satisfaction of interest seems to me to be more the application of a compound formula than crediting “as, on account or in lieu of payment of, or in satisfaction of interest”.
In short, the Court was of the view that a strict interpretation of s. 212(1)(b) leads to interpreting the word "credit" according to its substance, "making available to", and not according to the form of making an entry "on the right side of an account. "
We are of the view that that decision of the Tax Court of Canada is similar to the case under review and that the conclusions of the Court can be applied to conclude that the taxpayer did not pay the increased and capitalized interest on an annual basis and did not credit the vendor with such interest.
20. We are of the view that the interest accrued and capitalized at the end of the first year does not constitute a loan of money. We are also of the view that the interest accrued in the second year and calculated on the interest capitalized in the first year (the "Interest") cannot be deducted from the Taxpayer's income pursuant to paragraph 20(1)(c) because it is not interest paid or payable on borrowed money or on an amount payable for property acquired. In our view, the Interest will be deductible pursuant to paragraph 20(1)(d) when it is paid if all the conditions for the application of that paragraph are otherwise satisfied.
We are also of the view that all the accrued and capitalized interest, including the accrued and capitalized interest at the end of the first year, was not credited to the Vendor and there was no need to pay tax pursuant to paragraph 212(1)(b). Similarly, withholding tax was not required. Tax pursuant to paragraph 212(1)(b) will apply when the interest is paid or credited to the Vendor.
Access to Information
21. For your information, unless exempted, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, the electronic library version can be provided. Alternatively, the client may request a severed copy using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Ms. Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.
We hope that these comments are of assistance.
Financial Sector and Exempt Entities Section
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch.
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