2 May 1991 Internal T.I. 9030807 F - Payments in Connection with the Financing of a Company's Operation

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.

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Re: Participating Debt Payment

Mr. Szyc of the Audit Opinions Section of Taxation Programs Branch referred your opinion request dated October 12, 1990 to us for reply.  We regret that other workload  has prevented an earlier response.

Facts

Our understanding of the facts is as follows:

1.     

2.     

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Disclosed Pursuant to the Access to Information Act

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Our Opinion

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As noted by Mr. Justice Abbott in British Columbia Electric Railway Co. Ltd. v. MNR 58 DTC 1022 (SCC) at p. 1027 in his comments on the predecessor to paragraph 18(1)(a):

Since the main purpose of every business undertaking is presumably to make a profit, any expenditure made "for the purpose of gaining or producing income" comes within the terms of s. 12(1)(a) whether it be classified as an income expense or as a capital outlay.

Once it is determined that a particular expenditure is one made for the purpose of gaining or producing income, in order to compute income tax liability it must next be ascertained whether such disbursement is an income expense or a capital outlay.

This statement was cited with approval by Mr. Justice Cattanach in deciding Riviera Hotel Co. Ltd. v. MNR 72 DTC 6142 (FCTD).  In determining that a premium, paid to discharge a mortgage was on capital account, Mr. Justice Cattanach reviewed the authorities supporting the principle that the cost of financing a business is a capital expense:

The leading authority for the proposition that the cost of financing a business is a capital expense is in Montreal Coke and Manufacturing Co. v. M.N.R.,(1944) A.C. 126.  In that case interest bearing bonds were converted into other securities carrying lower rates of interest.  It was claimed that the expenses of conversion were incurred "for the purpose of earning income". The Supreme Court of Canada held that the payment" on that account were not for that purpose and that in any event, the expenses were outgoings of capital and accordingly were not deductible.  This decision was upheld by the Privy Council on the first ground.

This decision was followed by the Supreme Court of Canada in Bennet & White Construction Co. Ltd. v. M.N.R., [1949] S.C.R. 287 [49 DTC 514], where it was held that commission payments were not allowable as deductible expenses since they were incurred in connection with the financing of the business and were not related to the income earning process.

We also considered David G. Broadhurst's summary in the 1989 Conference Report ("Income Tax Treatment of Foreign Exchange Forward Contracts, Swaps and Other Hedging Transactions" p. 26:13):

The case law in Canada has consistently regarded payments made in connection with the financing of a company's operation as being on capital account unless the taxpayer is engaged in a money-lending business.  For example, interest, guarantee fees, and costs and expenses incurred in refinancing existing debt have all been held to be on capital account.  There is an exception if the costs relate to a temporary borrowing of the taxpayer that does not constitute part of its capital.

Although many of the cases are old, their continuing force has been emphasized in the Recent Bronfman [The Queen v. Bronfman Trust 87 DTC 5059 (SCC)] and Bowater Canadian [Bowater Canadian Limited v. The Queen 87 DTC 5287 (FCA).

Accordingly, it is our opinion that

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Deductibility under paragraph 20(1)

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The Department's view on participation payments was summarized at the 1989 Corporate Management Tax Conference at p. 8:9.  Mr. C. B. Darlingng (Director, Financial Industries Division) stated the Department's view that, on the basis of Miller v. The Queen 85 DTC 5354 (FCTD):

... a payment must satisfy all three of the following criteria to qualify as interest:

1)     it must be calculated on a daily accrual basis;

2)     it must be calculated on a principal sum or a right to a principal sum; and

3)     it must represent compensation for the use of the principal sum or the right to the principal sum.

To be referable to a principal sum, amounts are usually determined by applying a percentage to that principal.  In our view, an amount that is determined on the basis of other criteria (such as cash flow, revenue, or net profit) is not referable to a principal sum ... the department will consider a participation payment to be interest provided that

1)      the payment is limited to a stated percentage of the principal;

2)   the limiting percentage reflects commercial interest rates prevailing between arm's-length parties at the time the loan is entered into; and

3)   no other facts indicate the presence of an equity investment.

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Deductibility under Paragraph 20(1)(e)

The Department's position on the applicability of paragraph 20(1)(e) in participation arrangements was also explained at the 1989 Corporate Management Tax Conference (p.8:11):

Some taxpayers have represented the view that participation payments are deductible under paragraph 20(1)(e), which authorizes a deduction for expenses incurred in the course of borrowing money used for an income earning purpose. The department, however, takes the view that paragraph 20(1)(e) does not authorize a deduction for payments made as compensation for the use of money. In our view, this interpretation is consistent with the taxation policy underlying paragraph 20(1)(e), namely, the provision of a deduction for incidental expenses incurred in the course of effecting a borrowing.

The decision in Yonge-Eglinton [MNR v Yonge-Eglinton Building Ltd 74 DTC 6180 (FCA)] dealt with commitment fees, which do not represent compensation for the use of borrowed funds.  As noted in that decision, the commitment fees were payable whether or not the taxpayer actually borrowed money and whether or not any unpaid principal balance existed.  Accordingly, Yonge-Eglinton does not conflict with our view of paragraph 20(1)(e).

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The test for deductibility under paragraph 20(1)(e) was stated by

Mr. Justice Thurlow in Yonge-Eglinton (p. 6183) as " ... whether the expense, in whatever taxation year it occurs, arose from the issuing or selling or borrowing..."

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Deductibility under paragraph 20(1)(f)

Paragraph 20(1)(f) only applies to an amount "...paid in the year in satisfaction of the principal amount..." of an obligation.  Subsection 248(1) defines the "principal amount" in relation to any obligation to mean the amount that, under the terms of obligation, is the maximum amount or the maximum aggregate amount, as the case may be, payable on account of the obligation by the debtor otherwise than on account of interest.

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subparagraph 20(1)(f)(ii) refers to "... the lesser of the amount so paid and the amount by which the lesser of the principal amount of the obligation and all amounts paid in the year or in any preceeding taxation year in satisfaction of the principal amount thereof exceeds the amount for which the obligation was issued ..."

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Summary

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J.C. ClarkChiefLeasing and Financing SectionFinancial Industries DivisionRulings DirectorateLegislative and Intergovernmental Affairs Branch

c.c. W. Szye Audit Applications Division