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) Income inclusion of participating payments received by a lender
(b) Characterization of payments received
Position: (a) 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.
(b) Any financing arrangement which calls for a participation payment but which does not specify a limiting percentage rate which reflects commercial interest rates may be a distribution of profits to the source of financing. The appropriate tax treatment by the recipient of a participation payment can only be determined upon an examination of all of the facts of a particular arrangement
Reasons: (a) Operation of the Act
(b) Department's position
XXXXXXXXXX 2008-029356
V. Srikanth
May 12, 2009
Dear XXXXXXXXXX :
Re: Income from Participating Loan
We are writing in response to your letter dated September 16, 2008 wherein you requested our views on the timing of the income inclusion from the distribution of profit of a participating loan and the characterization of such income.
The relevant facts can generally be summarized as follows:
A Canadian-controlled private corporation ("CCPC"), LoanCo, makes a loan to Holdco, another CCPC. LoanCo and Holdco deal at arms length. HoldCo advances the loan funds to its wholly-owned subsidiary, DevelopCo, also a CCPC. The terms of the loan are such that it includes both a fixed rate of interest and a profit participation component. The profit participation component is not fixed and is not limited to a stated percentage of the principal. The profit participation is further contingent upon any profit that DevelopCo makes at the time of completion of the project, which is expected to be 3 years after the making of the loan.
You would like our opinion on the following issues:
- The timing of an income inclusion, and
- The characterization of the income, for tax purposes, as (i) active business income, (ii) income from a specified investment business subject to the general corporate tax rate, or (iii) income from property eligible for refundable Part I tax.
Our Comments
Please note that written confirmation of the tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R5. As stated in paragraph 22 of Information Circular 70-6R5, written opinions are not advance tax rulings and, accordingly, are not binding on the Canada Revenue Agency ("CRA"). Therefore, although we are not able to comment directly on the hypothetical facts submitted with your correspondence, we would offer the following general comments regarding the income inclusion from a participating loan.
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 Income Tax Act (the "Act"), or as accrued pursuant to subsection 12(3) of the Act (for a corporation, partnership or certain unit trusts) and subsection 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 as described in Income Tax Regulation 7000(1)(a) to (d), 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.
The CRA's longstanding published position is that, a participation payment may be considered to be interest where:
- the payment is limited to a stated percentage of the principal;
- the limiting percentage reflects the commercial interest rates prevailing between arms length parties at the time the loan is entered into; and
- no other facts indicate the presence of an equity investment.
It is to be noted that the Court's decision in Sherway Centre Limited v. The Queen ("Sherway"), FCA 1998/02/05 Docket: A-741-96, 98 DTC 6121, [1998] 2 CTC 343, in our view, amounted to a factual determination in that all of the documents and the evidence presented in Court indicated that the participating loan payments were intended to increase the yield on the loan to the prevailing market rate. Further, it is the CRA's position that, where all the published criteria are not satisfied but the evidence shows, as it did in Sherway, that the participation payments are intended to increase the interest rate of the loan to the prevailing market rate, we will consider the payments to be interest.
As indicated above, the CRA will generally consider a participation payment to be "interest" provided, inter alia, that there are no facts that indicate the presence of an equity investment. In this regard, the CRA 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.
We note that, in your scenario, the participating amount will be calculated as a percentage of profit and that it is not limited to a stated percentage of principal. Further, there will be no payment if there is no profit and there is no indication that the amount is intended to equate to a commercial interest rate. All of these factors support the conclusion that the participating amount may be a distribution of profit. However, resolution of how a payment should be treated for tax purposes, the timing of its income inclusion and the characterization for tax purposes as, for example, active business income, is a question of fact which can only be determined following a thorough analysis of all relevant documents and agreements between the parties involved. In our view, your enquiry would best be dealt with in the context of an advance income tax ruling such that we would have the opportunity to fully review all of the facts and relevant agreements.
We trust our comments will be of assistance to you.
Yours truly,
R.A. Albert, CA
For Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch
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