23 August 1991 External T.I. 9111065 F - Deductibility of Interest - Loan Agreement

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.

5-911106

Dear Sirs:

This is in reply to your letter dated April 5, 1991, in which you requested our interpretation of paragraph 20(1)(e) of the Income Tax Act (the "Act") in the following hypothetical situation. In summary you outline the following situation:

1.     

2.                            24(1)

3.     

4.     

5.     

You want the Department's comments on the following:

    (a)

    (b)

    (c)                 24(1)

Our comments

Since the situation described in your letter appears to contemplate a completed transaction involving specific taxpayers, it should be directed to your District Taxation Office which has the responsibility of determining the tax consequences of completed transactions and their effect on the particular taxpayers.  However, we are prepared to offer the following general comments.

Whether an amount paid or payable per a loan agreement is interest for the purpose of paragraph 20(1) (c) of the Act or whether an amount is deductible from income pursuant to paragraph 20(1) (e) of the Act is a question of fact that can only be determined from a review of all the circumstances of a particular situation.

At page 8:9 of the 1989 Corporate Management Tax Conference , the Department stated the following concerning the tax implications of participating loans:

The department's concern in respect of participating loans is to determine whether such loan arrangement effect a distribution of profits or are an expense of doing business. A distribution of profits should be on a tax-paid rather than a tax-deductible basis.

No clear dividing line exists in law to distinguish debt payments from equity payments. As a general rule, the department takes the view that a lender's return on debt does not depend on the profitability of the borrower, whereas an investor's return on equity does depend on profitability.  On this view of the matter, most participating loan arrangements qualify as equity rather than debt.

Some taxpayers have represented the view that participation payments are deductible under paragraph 20(1) (c), which authorizes a deduction for amounts paid or payable pursuant to a legal obligation to pay interest. It is, however, doubtful that most participation payments qualify as interest.  On the basis of the Miller case (Miller v. The Queen 85 DTC 5354), 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. While it is possible to create formulas under which amounts calculated on the basis of those other criteria are expressed as a percentage of the principal sum, the mere expression of such an amount in this manner does not necessarily qualify the amount as interest.

This is not to say that participation payments can never qualify as interest. As noted earlier, the question centres around the distinction between debt and equity payments that exhibited debt rather than equity characteristics ...

... In accordance with this position, 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

The relevant commercial interest rates will be those reflecting ordinary credit risks involved in a debt investment.  Accordingly, the limiting percentage may reflect any increased credit risk arising as a result of the credit rating of the borrower.  The limiting percentage may also reflect the risk that the lender may not receive all of the anticipated payments owing to insufficient profits in any one year.  An inordinate rate may well indicate that the "lender" is assuming risks that are more in keeping with an equity investment ...

... 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 expenditures incurred in the course of effecting a borrowing.

Some of the conditions that have to be satisfied before an amount paid or payable as interest is deductible pursuant to paragraph 20(1) (c) of the Act are as follows:

-         the interest is payable in respect of the year the deduction  is requested (for a taxpayer on the accrual basis);

-         there is a legal obligation to pay the interest on the borrowed money;

-         the borrowed money was used for the purpose of earning income from a business or property or for property acquired   for the purpose of gaining or producing income therefrom or from a business;

-         the amount paid as interest is reasonable.

An amount is considered to be payable if there is an absolute and unconditional legal obligation to pay the amount even though payment may not be due until a later date . See, for example, J . L, Guay Ltée v. MNR, 71 DTC 5423 (FCTD), aff'd 73 DTC 5373 (FCA), aff'd 75 DTC 5094 (SCC) and The Oueen v. Ken & Ray's Collins Bay Supermarket Ltd. 75 DTC 5346 (FCTD).

The phrase "in respect of the year" was considered in MNR v. Midwest Abrasive Co. of Canada Ltd. 73 DTC 5429 (FCTD).  In that case, interest was payable "if and when" some event occurred.  In Midwest interest was payable if and when it was requested by Midwest's parent company and Midwest was attempting to deduct interest in one year that related to prior years; the court disallowed that portion of the interest paid in the year that was payable in respect of prior years.

Assuming that a bonus interest payment is in fact interest and not an equity payment, it is our view that only the amount of the bonus interest payable in respect of a given year (assuming the taxpayer reports his income on the accrual basis) while the loan is outstanding is deductible in that given year pursuant to paragraph 20(1) (c) of the Act.  As noted in the aforementioned position, the Department takes the view that paragraph 20(1)(e) of the Act does not authorize a deduction for payments made as compensation for the use of borrowing money.  That provision is therefore not applicable to bonus interest in our view.  Moreover, it is our opinion that any lump sum settlement of future obligations in respect of bonus interest could not be regarded as interest since it cannot be regarded as compensation for the use of money after repayment of the principal sum.  Such an expenditure may qualify however, as an eligible capital expenditure pursuant to paragraph 14(1) (b) of the Act.

The views expressed in this letter are provided in accordance with the practice described in paragraph 21 of Information Circular 70-6R2 and are not binding on the Department.

We regret the delay in responding to your letter.

Yours truly,

for Director Bilingual Services & Resource  Industries Division Rulings Directorate