26 August 2013 Internal T.I. 2013-0494211I7 - participating debt interest

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: Is interest paid by a Canadian resident to a US resident subject to 15% Canadian withholding tax pursuant to subparagraph 6(b) of Article XI of the Canada-US Income Tax Treaty, where the interest is computed by reference to a public benchmark commodity index?

Position: Yes.

Reasons: The value of certain property owned by the borrower fluctuates in reference to the price of the commodity on the index.

August 26, 2013

Blair Hammond Angelina Argento
Senior Advisor – Tax Treaties IT Rulings Directorate
International, Provincial and (514) 283-7895
Strategic Policy Division
Legislative Policy Directorate

2013-049421

Subparagraph 6(b) of Article XI of the Canada-U.S. Income Tax Convention ("Treaty")

We are responding to your email of June 24, 2013 wherein you ask whether interest (which is "participating debt interest" within the meaning of subsection 212(3) of the Act because it is calculated with reference to commodity price; specifically the index value of oil and gas), paid by a corporation resident in Canada ("Canco") to a resident of the US (which is a "qualifying person" within the meaning of Article XXIX-A of the Treaty), is subject to 15% Canadian withholding tax pursuant to subparagraph 6(b) of Article XI of the Treaty? You ask us to assume Canco carries on business related to the acquisition, exploration and development of oil and gas properties in Canada and its principal assets consist of rights to explore for and exploit oil and gas; however, Canco does not currently own any inventory of oil or gas.

Our Comments

Paragraph 6 of Article XI of the Treaty

Pursuant to subparagraph 6(b) of Article XI of the Treaty, interest arising in Canada and paid to a resident of the US that is determined by reference to the receipts, sales, income, profits or other cash flow of the debtor or a related person, to any change in the value of any property of the debtor or a related person or to any dividend, partnership distribution or similar payment made by the debtor or a related person may be taxed in Canada at the same 15% withholding tax rate that applies to "portfolio" dividends under subparagraph 2(b) of Article X of the Treaty.

Pursuant to subparagraph 6(a) of Article XI of the Treaty, interest arising in the US and paid to a resident of Canada that is contingent interest of a type that does not qualify as portfolio interest under US domestic law may be taxed in the US at the same 15% rate.

Section 871(h)(4) of the (U.S.) Internal Revenue Code ("Code")

We note that the exception in subparagraph 6(b) of Article XI of the Treaty, for certain types of interest arising in Canada, uses the same language as is used in section 871(h)(4) of the Code which provides, inter alia, that contingent interest includes interest determined by reference to any change in value of any property of the debtor or a related person. Section 871(h)(4)(C) of the Code is an exception to section 871(h)(4) which sets forth several types of interest that continue to qualify as "portfolio interest" (and thus, are exempt from US withholding tax when received by a foreign person), notwithstanding the contingent nature of the interest. For example, pursuant to section 871(h)(4)(C) of the Code, interest is not contingent interest merely because it is determined by reference to changes in the value of property (footnote 1) (or any index value of property (footnote 2)) that is actively traded (footnote 3) other than a U.S. real property interest.

In our view, it appears that the US would consider the words in section 871(h)(4) of the Code to capture interest based on the index value of a commodity if the debtor held property that fluctuated in value in reference to the value of the commodity, otherwise the exception from 871(h)(4) in 871(h)(4)(C)(v)(III) of the Code would be unnecessary. In other words, it appears that absent a specific exclusion in section 871(h)(4)(C) of the Code for interest determined by reference to the index value of an actively traded property (such as a commodity), interest paid by a borrower who held oil and gas property, which interest is calculated with reference to the index value of oil and gas, would be contingent interest within the ambit of section 871(h)(4) of the Code and would not be exempt from US withholding tax because it is determined by reference to any change in value of any property of the debtor.

Subparagraph 6(b) of Article XI of the Treaty

We note that the legislated exceptions in section 871(h)(4)(C) of the Code (to what constitutes contingent interest for purposes of section 871(h)(4) of the Code) do not exist in subparagraph 6(b) of Article XI of the Treaty or in our domestic legislation. Thus, although, US source interest that is determined by reference to the index value of certain actively traded property would satisfy the stated exception to section 871(h)(4) of the Code (and thus, would not fall within the ambit of subparagraph 6(a) of Article XI of the Treaty), such contingent interest arising in Canada and paid to a resident of the US would not necessarily be excluded from the ambit of subparagraph 6(b) of Article XI of the Treaty.

The alternative view is that in order to fall within the words "interest …determined with reference to any change in value of any property of the debtor" in subparagraph 6(b) of Article XI of the Treaty, the interest must be tied to the changes in the appraised value of a specific property or properties of the debtor. In the example under consideration, since the interest is determined by reference to a public benchmark commodity index and not with reference to the value of any specific property on the debtor's balance sheet, the interest would not be captured by subparagraph 6(b) of Article XI of the Treaty. However, we believe that such view would render the words "interest determined with reference to any change in value of any property of the debtor" in subparagraph 6(b) of Article XI of the Treaty to have no force or effect. This is so because it leads to the conclusion that interest computed with reference to a commodity price could never be "interest determined with reference to any change in value of any property of the debtor" and the only words in the definition of "participating debt interest" in subsection 212(3) of the Act that could possibly capture "interest determined with reference to any change in the value of property of the debtor" for the purposes of subparagraph 6(b) of Article XI of the Treaty, are the words "…interest computed by reference to …commodity price…". Therefore, in our view, context requires that the reference to "interest determined with reference to any change in value of any property of the debtor" in subparagraph 6(b) of Article XI of the Treaty be read broadly so as to capture interest which is computed by reference to the price of a commodity, where there is a link or connection between the commodity price and the value of any property of the debtor.

As a result, we are of the view that subparagraph 6(b) of Article XI of the Treaty forces a determination as to whether there is a strong enough link between the value of the debtor's property and the value of a commodity on an exchange, so that interest linked to the index price of a commodity will fall within the ambit of subparagraph 6(b) of Article XI of the Treaty. Since Canco's principal assets consist of resource property rights that it holds for the purpose of extracting the commodities that make up the index, then in our view, there is a sufficient link between the interest (which is computed by reference to the commodity index) and the change in value of the debtor's property (i.e. the rights), such that the interest falls within the ambit of subparagraph 6(b) of Article XI of the Treaty and therefore is subject to Canadian withholding tax at a rate of 15%.

We trust these comments will be of assistance.

Olli Laurikainen, CPA, CA
for Director
International Section II
International Division
Income Tax Rulings Directorate

FOOTNOTES

Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:

1 Section 871(h)(4)(C)(v)(I) of the Code.
2 Section 871(h)(4)(C)(v)(III) of the Code.
3 Within the meaning of that term in section 1092(d) of the Code.