15 December 2009 External T.I. 2009-0339191E5 - Who should file an agreement pursuant to 78(1)(b)?

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: Which of Company B or Company C should file the election with Company A in the third taxation year following Year XX?

Position: The election or agreement pursuant to paragraph 78(1)(b) should be filed between Company A and Company B.

Reasons: Based on the statutory interpretation of 78(1), the interest payable is an amount that was owing by Company A to Company B, a person with whom Company A was not dealing at arm's length at the time the interest expense was incurred. Since the amount owing remained unpaid at the end of the second taxation year subsequent to the year the interest expense was incurred, paragraph 78(1)(b) requires that Company A (the taxpayer) and Company B (that person) file an agreement in prescribed form by the necessary deadline.

XXXXXXXXXX 	2009-033919
		Henry Leung
December 15, 2009

Dear XXXXXXXXXX :

Re: Interpretation of paragraph 78(1)(b) of the Income Tax Act.

This is in reply to your letter of September 1st, 2009 wherein you asked for our opinion on the matter described below.

The particular situation outlined in your letter relates to a factual one, involving a specific taxpayer. As explained in Information Circular 70-6R3, it is not this Directorate's practice to comment on proposed transactions involving specific taxpayers other than in the form of an advance income tax ruling. Should your situation involve a specific taxpayer and a completed transaction, you should submit all relevant facts and documentation to the appropriate Tax Services Office for their views. However, we are prepared to offer the following general comments which may be of assistance.

You described the following circumstances:

• Companies A, B and C are all related.
• Company A is a resident of Canada and is not fiscally transparent under the taxation laws of the United States, while Company B is a Limited Liability Corporation (LLC) that is not a resident of Canada and is fiscally transparent under the taxation laws of the United States; Company C will be incorporated in the U.S.
• In Year XX, Company A borrowed money from Company B on which it deducted an amount in respect of interest.
• At the end of the second taxation year following Year XX, Company A has not paid the interest to Company B. Company B will sell the right to receive the interest to Company C.

In the third succeeding taxation year following Year XX, Company A would be entitled to file an election under paragraph 78(1)(b) to avoid having to include the amount of the interest expense deducted in income under paragraph 78(1)(a). The question arises as to which of Company B or C should file the election with Company A in the third succeeding taxation year following Year XX.

Prior to the enactment of The Fifth Protocol (the "Protocol") to the Canada-U.S. Income Tax Convention (the "Treaty") which entered into force on December 15, 2008, an interest payment made by Company A to Company B was not eligible for the treaty-reduced rate of 10%. Article IV(6), which was enacted as part of the Protocol, extends the Treaty benefits to certain fiscally transparent entities (such as Company B) (to the extent that their shareholders are eligible). In the case of payments (e.g. interest, dividends, royalties) subject to withholding tax, this extension is effective beginning on February 1, 2009.

As well, the Protocol provides that interest payments made to a related person who is entitled to benefits under the Treaty will be subject to reduced withholding tax rates that will be phased in over three years for interest paid in the respective year as follows: 2008 - 7%; 2009 - 4%; and 2010 and on - 0%.

The Protocol extends Treaty benefits, effective February 1, 2009, to interest paid to Company B to the extent that the interest is deemed by Article IV(6) to be derived by a person who is entitled to Treaty benefits in respect of that item of income. Accordingly, any deemed payment of interest to Company B made on or after February 1, 2009 may be eligible for reduced withholding tax rates.

In the scenario you described, we will therefore make the following assumptions: the accrued interest expense occurred in 2006; it remained unpaid by December 31, 2008; and the deemed payment pursuant to subsection 78(1) occurred on January 1, 2009. This would subject any interest payments made or deemed to be made to Company B to a 25% withholding tax rate. Accordingly, there is an apparent incentive to have the payment made to Company C as opposed to Company B. If the agreement under paragraph 78(1)(b) were signed between Company A and Company B, there would be a higher amount of Part XIII tax payable since the deemed payment made in the third succeeding taxation year (i.e. January 1, 2009) following Year XX (i.e. 2006) would be subject to the 25% tax rate. On the other hand, if the agreement were between Company A and Company C, we assume that the deemed interest payment would be subject to a 4% tax rate.

In our view, paragraph 78(1)(b) would require the agreement to be filed between Company A and Company B. This conclusion is based on the interpretation of the subsection 78(1):

Where an amount in respect of a deductible outlay or expense that was owing by a taxpayer to a person with whom the taxpayer was not dealing at arm's length at the time the outlay or expense was incurred ... is unpaid at the end of that second taxation year, either

(a) the amount so unpaid shall be included in computing the taxpayer's income for the third taxation year following the taxation year in which the outlay or expense was incurred, or

(b) where the taxpayer and that person have filed an agreement in prescribed form on or before the day on or before which the taxpayer is required by section 150 to file the taxpayer's return of income for the third succeeding taxation year, for the purposes of this Act the following rules apply: ....

The interest payable is an amount that was owing by Company A to Company B, a person with whom Company A was not dealing at arm's length at the time the interest expense was incurred. Since the amount owing remained unpaid at the end of the second taxation year subsequent to the year the interest expense was incurred, paragraph 78(1)(b) requires that Company A (the taxpayer) and Company B (that person) file an agreement in prescribed form by the necessary deadline.

I trust the foregoing is of assistance.

Yours truly,

Randy Hewlett
Director
Business and Partnerships Division