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 a payment is an "excluded amount" for purposes of paragraph 20(1)(e)
Reasons: Clause 20(1)(e)(iv.1)(C) defines an “excluded amount” as an amount that is computed by reference to revenue, profit, cash flow, commodity price or any similar criterion or by reference to dividends paid or payable to shareholders of any class of shares of the capital stock of a corporation. In this situation, the payment in question is calculated by reference to a "similar criterion".
January 21, 2015
Legislative Application Section HEADQUARTERS
Large Business Audit Income Tax Rulings
Attention: XXXXXXXXXX Directorate
This is in response to your email of XXXXXXXXXX. You have asked for our views regarding whether an amount paid by XXXXXXXXXX (“Canco”) is an “excluded amount” as contemplated by clause 20(1)(e)(iv.1)(C) of the Income Tax Act (Canada) (the “Act”). Paragraph 20(1)(e) of the Act generally provides for an amortized deduction for certain financing expenses other than for excluded amounts.
Clause 20(1)(e)(iv.1)(C) of the Act defines the following as an “excluded amount”: “an amount that is computed by reference to revenue, profit, cash flow, commodity price or any similar criterion or by reference to dividends paid or payable to shareholders of any class of shares of the capital stock of a corporation”.
The explanatory notes to paragraph 20(1)(e) state:
Paragraph 20(1)(e) is amended to clarify that it does not allow a deduction for profit participation and similar payments — that is, payments dependent on the use of or production from property, or computed by reference to revenue, profits, cash flow, commodity prices or any other similar criterion or by reference to dividend payments. Where such payments are compensation for the use of borrowed money or for the right to pay a debt over time, they would be excluded by the existing paragraph 20(1)(e) — either because they are interest or because they fall within the broad definition of “principal amount” in subsection 248(1). The amendment ensures that in no circumstances can participation and similar payments be deducted under paragraph 20(1)(e).
1. On XXXXXXXXXX, Canco and XXXXXXXXXX (“XXXXXXXXXX”, together with Canco being the “Obligors”) as guarantor entered into a credit agreement (the “Credit Agreement”) with XXXXXXXXXX (the “Lender”) XXXXXXXXXX. Under the Credit Agreement, Lender loaned (the “Loans”) an aggregate of $XXXXXXXXXX to Canco at a stipulated interest rate. The Loans were due to mature on XXXXXXXXXX. The Loans were used to refinance existing loans which, in turn, were used in Canco’s business.
2. Section XXXXXXXXXX of the Credit Agreement provided that “XXXXXXXXXX”. The Liquidity Payment Agreement (the “LPA”) with Lender was also dated XXXXXXXXXX and contained the following recital: “XXXXXXXXXX”.
3. The “Liquidity Payment” is defined in section XXXXXXXXXX of the LPA. In very basic terms, the Liquidity Payment is equal to XXXXXXXXXX% of an amount determined by a formula. The formula begins with “Enterprise Value”, and then subtracts a number of items such as indebtedness, share subscription proceeds, certain undistributed amounts and certain taxes. Generally, this formula relates to both of the Obligors, not just Canco.
4. “Enterprise Value” is defined in section XXXXXXXXXX of the LPA to mean, with respect to a “Liquidity Event” or deemed Liquidity Event, “the gross enterprise value of the assets and Business, as a going concern, of the Obligors including net working capital at the time of the Liquidity Event or the Valuation Date”, subject to certain adjustments. Under clause XXXXXXXXXX of the LPA, where the Liquidity Event is a sale of all of the “Participating Securities” of Canco, the Enterprise Value is deemed to be the gross share purchase price, plus all “Funded Indebtedness” of the Obligors plus certain notes plus the issue price of any shares of Canco other than the Participating Securities plus accrued and unpaid dividends thereon. Clause XXXXXXXXXX of the LPA contains a similar concept for a public offering or sale of less than all of the Participating Securities of the Borrower.
5. Under section XXXXXXXXXX of the LPA, the Liquidity Payment was due upon the occurrence of a “Liquidity Event” or “Partial Liquidity Event”, as those terms are defined under the LPA. Generally, those events included such events as a change of control, sale of certain securities to the public or a sale of all or substantially all of the assets of the Obligors. Provided that certain requirements were met, the LPA would terminate on the earlier of the making of a Liquidity Payment and XXXXXXXXXX.
6. Subsequently Lender assigned its rights under the Credit Agreement to XXXXXXXXXX. Following the assignment, the Credit Agreement was amended and the maturity date of the Loans was extended to XXXXXXXXXX. The LPA was not assigned.
7. On XXXXXXXXXX Canco repaid the Loans in full.
8. As a result of certain transactions in XXXXXXXXXX, Lender claimed that it was owed a Liquidity Payment under the LPA. The claim went to arbitration (pursuant to the procedures contemplated under the LPA). XXXXXXXXXX. After XXXXXXXXXX, the parties reached a settlement. XXXXXXXXXX. Under the settlement, Canco paid $XXXXXXXXXX (the “Payment”) in relation to the Liquidity Payment and $XXXXXXXXXX in interest.
10. Canco incurred legal fees of $XXXXXXXXXX and $XXXXXXXXXX in XXXXXXXXXX and XXXXXXXXXX, respectively, XXXXXXXXXX. Canco treated the fees as eligible capital expenditures.
Is the Payment an “excluded amount” as contemplated by clause 20(1)(e)(iv.1)(C) of the Act?
The taxpayer’s representative makes the following arguments in support of the position that the amount actually paid by Canco is not an “excluded amount” under clause 20(1)(e)(iv.1)(C) of the Act.
First, the taxpayer’s representative argues that “Enterprise Value” is not revenue, profit, cash flow, commodity price or “any similar criterion”. Focusing on the “any similar criterion” element, the taxpayer’s representative argues that “any similar criterion” must be of the same class or kind as revenue, profit, cash flow and commodity price. Further, the taxpayer’s representative argues that revenue, profit, cash flow and commodity price are “indicative of an objectively measurable income statement like criterion or financial metric (e.g. dividends) that affects the income statement”. Rather, the taxpayer’s representative argues that “Enterprise Value” is a “business valuation involving goodwill”. The taxpayer’s representative indicates that the inputs to the “Enterprise Value” concept include a number of elements that are not specifically or explicitly revenue, profit, cash flow or commodity price, and that “Enterprise Value” is not a surrogate or proxy thereof. In addition, the taxpayer’s representative indicates that “Enterprise Value” is not necessarily correlated with revenue, profit, cash flow or commodity price in that “Enterprise Value” may be quite high in the face of low profits, or vice-versa.
Second, the taxpayer’s representative argues that XXXXXXXXXX. The taxpayer’s representative states:
The Payment is an “excluded amount” under clause 20(1)(e)(iv.1)(C) of the Act.
The Payment is an “excluded amount” under clause 20(1)(e)(iv.1)(C) of the Act. In your view, the evidence demonstrates that the Lender XXXXXXXXXX but was unable to do so. Therefore, the Lender XXXXXXXXXX. You are also of the view that notwithstanding that the Payment was XXXXXXXXXX were clearly based on an analysis of Canco’s historical and projected profits, cash flows and earnings.
1. Would the Liquidity Payment have been an “excluded amount”?
There are a number of places in the Act that use similar or identical language to that used in clause 20(1)(e)(iv.1)(C). The definition of “participating debt interest” in subsection 212(3) and paragraph 18(9.1)(b) of the Act are two examples.
The explanatory notes to the definition of “participating debt interest” state, in part, that that term “is, very generally speaking, interest that depends on the success of the payer's business or investments. In its details, the definition draws directly from the concluding portion (the postamble) of existing paragraph 212(1)(b), and it is intended to have the same effect”. The explanatory notes to the postamble do not state anything material.
Rulings has issued a number of technical interpretations and rulings relating to the question of whether a payment computing by reference to a stock price or a stock exchange index could constitute “participating debt interest” or, under its previous iteration, could fall under the postamble of paragraph 212(1)(b) of the Act. We have considered the old Rulings views in respect of the postamble in paragraph 212(1)(b) in interpreting the “excluded amount” definition because the wording of the postamble is virtually identical to the wording in subparagraph 20(1)(e)(iv.1).
In 9915455 (July 21, 1999), Rulings stated:
It is our view that interest payments which fluctuate on the basis of a formula that seeks to determine the extent to which the stock price of the borrower either out-performs or under-performs the short-term money market index would fall within the broad concluding words of paragraph 212(1)(b) “all or any portion of the interest…is computed by reference to…revenue, profit, cash flow, commodity price or any other similar criterion”.
In 2000-0011015 (May 16, 2000), Rulings stated that a return on a debt calculated by reference to the Dow Jones Industrial Average could be considered to be a return computed by reference to a commodity price, with the commodity being the stock on which the index was based.
In 2000-0046375 (November 22, 2000), Rulings considered a debt obligation the return on which was calculated by reference to the change in an internationally recognized foreign stock exchange. In considering whether the return would be “computed by reference to revenue, profit, cash flow, commodity price or any similar criterion” for purposes of the postamble to former paragraph 212(1)(b), Rulings stated:
The Agency would not generally consider the return computed by reference to a stock index to be so computed as long as the Agency is satisfied that the particular index chosen is not influenced by the inclusion in that index of shares of the issuing corporation, corporations related to the issuing corporation or a corporation or corporations whose primary business is substantially similar to that of the issuing corporation. Such an influence could lead to a conclusion that changes in the index represent a “similar criterion” for the computation of interest by reference to revenue, profit, cash flow or commodity price as described in the aforementioned postamble.
Also, the Agency would want to be satisfied that the debt obligation is not used by a non-resident of Canada as a substitute for a direct investment in the underlying securities in an index where dividends or gains on those securities would be subject to tax in Canada if held directly by that non-resident…
In 2001-0096655 (October 9, 2001), Rulings considered the potential application of the postamble to a debt the return on which was calculated by reference to a stock exchange. Rulings stated that it would not apply the postamble “as long as the Agency is satisfied that the particular index chosen is not influenced by the inclusion in that index of the shares of the issuing corporation, corporations related to the issuing corporation or corporations whose primary business is substantially similar to that of the issuing corporation. Such an influence could lead to a conclusion that changes in the index represent a ‘similar criterion’…”
The taxpayer’s representative argues that the other factors to which the “similar criterion” must be compared, namely, revenue, profit, cash flow and commodity price, are all objectively measurable income statement-like criteria or financial metrics, whereas “Enterprise Value” is a business valuation that does not necessarily include any of the enumerated criteria, is not a surrogate or proxy for the enumerated criteria and indeed may be entirely independent of the enumerated criteria. Given that Rulings has a long-standing position that share value is a “similar criterion”, the question is, instead, whether “Enterprise Value” is sufficiently similar to share value where the shares are traded on a stock exchange. In our view, the fact that share value is determined via appraisal rather than trading price is not a sufficiently material difference to allow Rulings to depart from its previous policy. Share price would generally be considered to reflect, at least in part, the profitability of the issuer’s business or investments. Regardless, to the extent that share price is considered to be a “similar criterion” because it is connected with profitability or similar factors, the same logic should be applicable to “Enterprise Value”. The fact that the valuation methodology is appraisal rather than trading price should not be relevant. We note that “cash flow” also requires some kind of valuation exercise, as, does “revenue”; neither of those criteria are ones that can be measured by reference to trading price. Finally, one would reasonably assume that a determination of “Enterprise Value” would be based in part on profit, revenue and cash flow. XXXXXXXXXX.
Finally, we note that some of the Rulings documents cited above specifically state that the former postamble to paragraph 212(1)(b) would apply unless the CRA was satisfied that the debt obligation in question was not being used as a substitute for a direct investment in underlying equities (in that case where dividends or gains earned by a non-resident on those equities would have been taxed in Canada). In this case, it is your view that the Liquidity Payment was used as a substitute for a direct equity investment that the Lender originally wanted but could not acquire. Accordingly, characterization of the Liquidity Payment as an excluded amount would be consistent with Rulings’ previous positions.
2. Does the negotiated nature of the Payment remove it from characterization as an “excluded amount” under clause 20(1)(e)(iv.1)(C)?
The taxpayer’s argument is that even if the Liquidity Payment itself would have been an “excluded amount”, the Payment is not an “excluded amount”. The taxpayer’s argument is that the quantum of the Payment was determined by negotiations between Canco and Lender, and that that process removed the Payment from characterization as an “excluded amount” either because it is not possible to understand exactly how the Payment was calculated or a variety of factors went into the calculation, including non-financial factors. Our view is that the focus of the discussion should be on whether the variety of different factors that would have contributed to the determination of the quantum of the Payment removes the payment from characterization as an “excluded amount”.
In our view, there are multiple approaches to consider. The first is whether one can argue that the Payment is still, in and of itself, an excluded amount because some of the basis for the determination of its quantum is the factors listed in clause 20(1)(e)(iv.1)(C). We then consider whether, if the negotiated nature of the Payment removes it from characterization as an “excluded amount”, the Payment also cannot be said to have been paid “in the course of borrowing money…” as required by subparagraph 20(1)(e)(ii) such that, prima facie, the Payment does not meet the requirements for deductibility under paragraph 20(1)(e).
a. Clause 20(1)(e)(iv.1)(C) factors still present
The primary argument in favour of treating the Payment as an “excluded amount” is that it is an amount that actually was “computed by reference to” Enterprise Value, which we have already concluded should be a “similar criterion”, as contemplated by clause 20(1)(e)(iv.1)(C).
It is our view that the Payment was an amount that was in between the estimates given by the two valuation experts. Valuation was one of the key matters (if not the only matter) still in issue between the Canco and Lender given that the arbitrator had already decided that a Liquidity Payment needed to be made; accordingly, the Payment appears to have been based on Enterprise Value. The basic parameters of the negotiations were the two different estimates of Enterprise Value. The fact that the parties disagreed on the quantum of Enterprise Value does not mean that the Payment was not calculated with reference to Enterprise Value. Accordingly, it is our view that the Payment was determined “by reference to” Enterprise Value, and therefore the Payment is an “excluded amount” for purposes of paragraph 20(1)(e).
b. Payment not made “in the course of a borrowing”
Alternatively, if the Payment is not an “excluded amount” because its negotiated nature removes it from that status, we would argue that the Payment would not be deductible under paragraph 20(1)(e) because it would not be considered to have been made “in the course of a borrowing”, as required by subparagraph 20(1)(e)(ii).
The logic of removing the Payment from “excluded amount” status because of its negotiated nature is that the Payment, being an amount paid pursuant to settlement discussions, is of a fundamentally different nature than the Liquidity Payment because the factors driving the negotiation are either unknown or not contemplated by the “excluded amount” definition. Accordingly, if the Payment is not an “excluded amount” because the factors that determined its quantum are either unknown or not contemplated by the “excluded amount” definition, then the Payment also can be viewed as not having been paid “in the course” of the borrowing because the Payment itself and the quantum of the Payment were not contemplated by the Credit Agreement.
The leading case on the meaning of the phrase “in the course of” in the context of paragraph 20(1)(e) or its predecessor is Minister of National Revenue v. Yonge-Eglinton Building Ltd.,  C.T.C. 209 (F.C.A.)). In this case, the Court considered whether participation-type payments made under a loan agreement could be deducted under the predecessor to paragraph 20(1)(e). The payments were payable regardless of whether any funds were advanced or outstanding. Justice Thurlow stated the following with regard to the “in the course of” requirement:
What appears to me to be the test is whether the expense, in whatever taxation year it occurs, arose from the issuing or selling or borrowing. It may not always be easy to decide whether an expense has so arisen but it seems to me that the words “in the course of” in paragraph 11(1)(cb) are not a reference to the time when the expenses are incurred but are used in the sense of “in connection with” or “incidental to” or “arising from” and refer to the process of carrying out or the things which must be undertaken to carry out the issuing or selling or borrowing for or in connection with which the expenses are incurred.
If the Payment’s negotiated nature distances it sufficiently from the Liquidity Payment such that the Payment can no longer be considered to be based on the same factors that underlie the Liquidity Payment, then one is required to consider whether the Payment’s negotiated nature causes it to not be an obligation arising “in the course of” the borrowing under the Credit Agreement.
On the basis of the various arguments set out above, it is our view that the Payment is an “excluded amount” for purposes of clause 20(1)(e)(iv.1)(C).
We trust that these comments will be of assistance.
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, following a 90-day waiting period (unless advised otherwise to extend this waiting period), 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 the taxpayer request a copy of this memorandum, they may request a severed copy using the Privacy Act criteria, which does not remove taxpayer identity. Requests for this latter version should be e-mailed to: LPRA-PLAR ITR-DDI Access Team-Équipe d'Accès. In such cases, a copy will be sent to you for delivery to the taxpayer.
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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