8 May 2018 CALU Roundtable Q. 1, 2018-0745491C6 - Back-to-back loans

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: 1. Is the condition in subparagraph 15(2.16)(c)(ii) met in the hypothetical scenario presented; notably, does the right to encumber described in the scenario constitute a "specified right", for the purposes of that subparagraph? 2. Is the condition in subparagraph 15(2.16)(c)(i) met in the hypothetical scenario presented?

Position: 1. Inconclusive based on the limited information provided in the hypothetical scenario. 2. If the right to encumber is not a specified right, then no; if the right to encumber is a specified right then it is not necessary to conclude.

Reasons: 1. A comprehensive review of all the terms and conditions of the funding arrangement between the relevant parties is required in order to determine if the right described in the hypothetical scenario is a "specified right", and consequently whether subparagraph 15(2.16)(c)(ii) applies. General comments provided. 2. If we assume that the right to encumber is not a specified right, then subparagraph 15(2.16)(c)(i) does not apply because the bank does not have an amount outstanding as or on account of a debt or other obligation connected to the shareholder debt in the manner described in that subparagraph. If we assume that it is a specified right, then it is not necessary to conclude whether subparagraph 15(2.16)(c)(i) applies because the condition in paragraph 15(2.16)(c) would already have been met because of subparagraph 15(2.16)(c)(ii).

CALU Roundtable -- May 2018

Question 1 - Section 15: Back-to-back loans

Background:

The 2016 Federal Budget introduced “back-to-back” shareholder loan rules now contained in subsections 15(2.16) to 15(2.192) of the Act. The operative rule is in subsection 15(2.17) and there are four conditions for its application, which are set out in paragraphs 15(2.16)(a) to (d).

In general, pursuant to the condition in subparagraph 15(2.16)(c)(ii), these rules may apply to an arrangement under which a Canadian resident corporation provides a “specified right”, as defined in subsection 15(2.192), in respect of a particular property, to a financial institution that loans an amount to a shareholder of the corporation, if it can reasonably be concluded that the loan by the financial institution to the shareholder was only made possible because of the specified right granted by the corporation.

The CRA issued a technical interpretation, dated October 31, 2017 (2017-0690691E5), confirming that the back-to-back shareholder loan rules apply in the following hypothetical situation (unofficial translation):

A 50% limited partner (Ms. X) funded her investment in a limited partnership (jointly owned with her husband) with a $3M bank loan that was secured by a pledge to the bank of a $3M term deposit held by a corporation equally owned by Mr. and Ms. X (Corporation B) with that bank. In finding that the back-to-back loan rules in subsection 15(2.16) et seq. deemed Ms. X to owe $3M to Corporation B, the CRA indicated that:

• The condition in paragraph 15(2.16)(a) was met because Ms. X had an amount outstanding ($3M) to an “immediate funder” (the bank);
• The condition in paragraph 15(2.16)(b) was met because subsection 15(2) would not apply to this scenario in the absence of subsections 15(2.16) and 15(2.17);
• The condition in paragraph 15(2.16)(c) was met because clause 15(2.16)(c)(i)(B) was met (i.e., the bank had a $3M term deposit outstanding to Corporation B that was required in order for the $3M loan to Ms. X to remain outstanding); and
• The condition in paragraph 15(2.16)(d) was met because, at that time, Corporation B was an “ultimate funder”, as defined in subsection 15(2.192).

With respect to whether a specified right was granted to the bank for purposes of subparagraph 15(2.16)(c)(ii), the CRA only stated that the pledge to the bank of the $3M term deposit might also constitute a specified right, but such a determination was not necessary in light of the fact that the condition in paragraph 15(2.16)(c) was already met because clause 15(2.16)(c)(i)(B) was met.

Questions:

The condition in paragraph 15(2.16)(c) can be met in one of two ways. Those two ways are outlined in subparagraphs 15(2.16)(c)(i) and 15(2.16)(c)(ii).

1. If the facts in 2017-0690691E5 were changed such that, instead of a $3M term deposit being obtained by Corporation B from the bank that made the loan to Ms. X in order to secure payment of that loan, Corporation B grants the bank a right to encumber (the “right to encumber”) one of its properties, such as: a term deposit with another lending institution, a corporate-owned life insurance policy, or an investment in a mutual fund (the “encumbered properties”), would the CRA conclude that the bank would not have a specified right in respect of the encumbered properties, such that the condition in subparagraph 15(2.16)(c)(ii) is not met? It should be noted that the other lending institution, the insurer of the life insurance policy and the mutual fund are all persons or partnerships dealing at arm’s-length with the bank in this scenario.

2. Would the CRA agree that the condition in subparagraph 15(2.16)(c)(i) would not be met in this scenario?

CRA Response

1. In the present scenario, the conditions in both paragraphs 15(2.16)(a) and (b) are met for the same reasons as set out in 2017-0690691E5. In particular:

• the condition in paragraph 15(2.16)(a) is met because Ms. X (i.e., the “intended borrower” (endnote 1)) has an amount outstanding (i.e., the $3M “shareholder debt” (endnote 2)) to the bank (i.e., an “immediate funder” (endnote 3)), and
• the condition in paragraph 15(2.16)(b) is met because subsection 15(2) would not apply to this scenario in the absence of subsections 15(2.16) and 15(2.17).

In order for subparagraph 15(2.16)(c)(ii) to apply, a funder (endnote 4) in respect of a particular funding arrangement (endnote 5) must be granted a specified right in respect of a particular property by a person or a partnership, and one of the two conditions stipulated in clauses (A) and (B) of that subparagraph must be met. In general, those two conditions require a connection between the specified right and the particular funding arrangement. More specifically, the condition in clause (A) states that the existence of the specified right must be required under the terms and conditions of the particular funding arrangement, and the condition in clause (B) states that it can reasonably be concluded that all or a portion of the particular funding arrangement was entered into or permitted to remain outstanding because the specified right was (or was anticipated to be) granted.

As stated in 2017-0703901C6, “…the specified right rule in subparagraph 15(2.16)(c)(ii) is generally meant to capture situations in which the corporation itself is the real source of the funding to the shareholder and not the intermediary. As such, where a security interest in the assets of the company is tantamount to putting assets in the hands of the intermediary for its general use, the shareholder loan rules will ordinarily apply.”

A specified right is defined in subsection 15(2.192) as having the same meaning as in subsection 18(5) but must be read with such changes as are required by the context of the domestic “back-to-back” loan rules in subsections 15(2.16) to 15(2.192). In general, a specified right is defined in subsection 18(5), at any time in respect of a property, to mean a right to, at that time

• mortgage, hypothecate, assign, pledge or in any way encumber the property to secure payment of an obligation (other than the particular debt or other obligation of the taxpayer or a "connected" debt or other obligation described in subparagraph 18(6)(d)(ii)), or
• use, invest, sell or otherwise dispose of, or in any way alienate, the property.

In the present scenario, the facts state that Corporation B will grant the bank the right to encumber one of its properties. Therefore, at the time of the grant, the bank may have a specified right, unless the exception set out in the parentheses above is met. If, under the arrangement between the parties, the bank can only exercise its right to encumber in order to secure payment of Ms. X’s $3M shareholder debt (for example, by placing a lien on the encumbered property to ensure that Corporation B cannot dispose of it without the bank’s consent), then the exception in parentheses would be met and the right to encumber would not constitute a specified right. However, if under the arrangement between the parties, the bank can exercise its right to encumber in order to raise capital for itself, then the exception in parentheses would not apply and the right to encumber would constitute a specified right. (endnote 6)

A comprehensive review of all the relevant legal documentation between the parties is therefore required in order to determine whether the right to encumber granted by Corporation B to the bank would be considered a specified right, and consequently, whether the condition in subparagraph 15(2.16)(c)(ii) is met.

2. In order for subparagraph 15(2.16)(c)(i) to apply, a funder, in respect of a particular funding arrangement, must have an amount outstanding as or on account of a debt or other obligation to pay an amount to a person or partnership (herein referred to as the “funder debt”) that meets one of the two conditions stipulated in clauses (A) and (B) of that subparagraph. In general, those conditions require a connection between the funder debt and the particular funding arrangement. More specifically, the condition in clause (A) states that recourse in respect of the funder debt must be limited to a funding arrangement, and the condition in clause (B) states that it may reasonably be considered that all or a portion of the particular funding arrangement was entered into or permitted to remain outstanding because all or a portion of the funder debt was (or was anticipated to be) entered into or permitted to remain outstanding.

In the scenario described in 2017-0690691E5, the funder (i.e., the bank), in respect of a particular funding arrangement (i.e., the $3M shareholder debt) had a $3M term deposit outstanding that was owed to a person (i.e., Corporation B), and that was required in order for the particular funding arrangement (i.e., the $3M shareholder debt) to remain outstanding. As a result, subparagraph 15(2.16)(c)(i) was applicable in that scenario by virtue of clause 15(2.16)(c)(i)(B).

In the present scenario, if we assume that the right to encumber does not constitute a specified right, then subparagraph 15(2.16)(c)(i) would not apply because the funder (i.e., the bank), and any person or partnership not dealing at arm’s length with the bank (endnote 7), does not have an amount outstanding as or on account of a debt or other obligation that is connected to the shareholder debt in the manner described in subparagraph 15(2.16)(c)(i), based on the facts.

If we assume the same facts, except that the right to encumber is a specified right and either of the conditions in clauses 15(2.16)(c)(ii)(A) or (B) are met (which would seem likely based on the given facts), then it is not necessary to consider whether the condition in subparagraph 15(2.16)(c)(i) is met because the conditions in paragraph 15(2.16)(c) would have already been satisfied such that subsection 15(2.17) would already apply in that scenario.

Nicki Verlinden
2018-074549
May 8, 2018

ENDNOTES

1 “Intended borrower” is a term used in paragraph 15(2.16)(a).

2 “Shareholder debt” is a term used in paragraph 15(2.16)(a).

3 An “immediate funder” is a term used in paragraph 15(2.16)(a) and is included in the definition of “funder” in subsection 15(2.192).

4 “Funder” is defined in subsection 15(2.192).

5 “Funding arrangement” is defined in subsection 15(2.192).

6 See examples 1 and 2 of the Department of Finance Technical Notes to subsection 18(6).

7 Included in paragraph (c) of the definition of “funder”.