24 June 2014 External T.I. 2014-0524331E5 - definition of excluded 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: Whether the refinancing of a debt would be considered a "substantial increase" in the indebtedness of a partnership for purposes of the definition of an "excluded interest" in subsection 40(3.15).

Position: It is a question of fact whether the refinancing of a debt would be considered to be a substantial increase in the indebtedness of a partnership for the purposes of the definition of "excluded interest" in subsection 40(3.15). In this particular scenario, it is our view that there is a substantial increase. Therefore, subsection 40(3.1) would apply.

Reasons: In this particular scenario, the refinancing results in an increase of over 40% in the indebtedness of the partnership.

XXXXXXXXXX
J. Gibbons
2014-052433

June 24, 2014

Dear XXXXXXXXXX:

Re: "Excluded Interest"

This is in response to your email of March 14, 2014, concerning the definition of an "excluded interest" in subsection 40(3.15) of the Income Tax Act (the "Act").

Subsection 40(3.1) of the Act deems certain members of a partnership to have realized a capital gain from the disposition of the member's interest in the partnership where the calculation of the member's adjusted cost base of such interest would otherwise be negative at the end of the partnership's fiscal period. Where a partnership interest that was held by a member on February 22, 1994 is an excluded interest, the partnership interest is grandfathered from the rules in subsection 40(3.1) of the Act.

In your email, you described a scenario in which a Canadian limited partnership (the "Partnership") has carried on the business of operating a residential apartment building since 1988, without any expansion to or changes in the activities of the partnership. However, the original mortgage loan was refinanced in 2013 resulting in an increase of over 40% in the amount of the Partnerships' indebtedness relative to the indebtedness existing immediately before the refinancing. Notwithstanding this increase, the total amount of the Partnership's indebtedness after the refinancing was less than the total amount of the indebtedness existing on February 22, 2004.

Your main question is whether the refinancing in 2013 would be considered to result in a "substantial increase in the indebtedness of the Partnership" within the meaning of subsection 40(3.15) of the Act. If so, an interest in the Partnership will not be considered an excluded interest unless the deeming rule in paragraph 40(3.16)(d) of the Act applies. This provision deems that an amount will be considered not to be substantial where the amount was used for an activity that was carried on by the partnership on February 22, 1994 but not for a significant expansion of the activity or for the acquisition or production of a film production. You indicated that subsection 40(3.15) of the Act should likely apply since there has been no expansion or change in the activities of the Partnership.

In your view, subsection 40(3.15) of the Act can be interpreted in two different ways, providing very different results in your particular scenario. One interpretation would be to treat the test in subsection 40(3.15) as a point-in-time test which, in your scenario, would result in there being considered to be a 40% increase in the Partnership's indebtedness. On the other hand, another interpretation would be to treat the test in subsection 40(3.15) as a comparison of the indebtedness at a particular time with the indebtedness existing at February 22, 1994. As indicated above, this would mean that the Partnership's indebtedness would actually be considered to have gone down rather than increased.

Our comments

This technical interpretation provides general comments about the provisions of the Act and related legislation (where referenced). It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of particular transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R5, Advance Income Tax Rulings.

Subsection 40(3.15) of the Act provides that "an excluded interest in a partnership at any time means an interest in a partnership that actively carries on a business that was carried on by it throughout the period beginning February 22, 1994 and ending at that time, or that earns income from a property that was owned by it throughout that period, unless in that period there was a substantial contribution of capital to the partnership or a substantial increase in the indebtedness of the partnership."

It is a question of fact whether there has been a substantial contribution of capital to the partnership or a substantial increase in the indebtedness of the partnership throughout any period beginning on February 22, 1994 and ending at a particular time within the meaning of subsection 40(3.15). In our view, this determination does not involve any particular test, such as a point-in-time test, but requires an analysis of all of the facts of a particular case throughout the period beginning February 22, 1994, and ending at that particular time. Based on the scenario you described, it is our view that there has been a substantial increase in the indebtedness of the Partnership throughout the period.

Notwithstanding the fact that there may have been a substantial contribution of capital or a substantial increase in the indebtedness of a partnership in a particular situation, paragraph 40(3.16)(d) of the Act deems that an amount will be considered not to be substantial where "the amount was used for an activity that was carried on by the partnership on February 22, 1994 but not for a significant expansion of the activity nor for the acquisition or production of a film production."

With regard to paragraph 40(3.16)(d) of the Act, you indicated that since there has been no expansion or change in the activities of the Partnership, it is your view that the proceeds of the Partnership's refinancing were used in the Partnership's business activities. We do not agree with your view. Pursuant to this provision, even where there has been no expansion or change in the activities of a partnership, the exception in paragraph 40(3.16)(d) of the Act will only apply if the partnership's new indebtedness was used for an activity that was carried on by the partnership on February 22, 1994. In your scenario, there is no indication that this was the case, but rather it appears that the amount received under the refinancing may have been used by the Partnership to make distributions to the partners. Accordingly, paragraph 40(3.16)(d) would likely not apply to the Partnership and therefore subsection 40(3.1) would apply.

We trust these comments will be of assistance.

Yours truly,

G. Moore
for Director
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch