24 May 1995 Internal T.I. 9505086 - ART XI(3)(e) Canada-U.S. Income Tax Convention

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

		May 24, 1995

P. J. Murphy		Rulings Directorate
	Section Chief		David R. Senécal
	Appeals & Referrals Division		(613)957-9796
	Headquarters-Appeals Directorate

Attention:Neil Wilson

			950508

XXXXXXXXXX

This is in reply to your memorandum of February 23, 1995, wherein you request our comments regarding the income tax implications arising out of the following fact situation:

• XXXXXXXXXX is a United States corporation which is not resident in Canada for the purposes of Part I of the Income Tax Act (the "Act").
• XXXXXXXXXX has a permanent establishment in Canada through which it carries on its Canadian operations.
• During the 1950's and 1960's, loans were made to the permanent establishment by

XXXXXXXXXX

Funds were also advanced by the Head Office of XXXXXXXXXX The monies were used by the permanent establishment to acquire assets in Canada and to fund its operations.

• During the late 1960's and the 1970's, the loans were refinanced and consolidated several times. Ultimately, in 1978, a note was issued by XXXXXXXXXX to XXXXXXXXXX to cover all notes or previously issued or advances outstanding as well as all accrued interest.
• The permanent establishment has never reimbursed any of the monies loaned to it nor has it paid any of the interest accruing on the loans. Prior to the coming into force of the Canada-U.S. Income Tax Convention (1980) (the "Convention") on January 1, 1986, the interest paid on these advances would have been exempt pursuant to the paragraph 2 of Article XII of the former 1942 Canada-U.S. Income Tax Convention.
• For the 1984, 1985 and 1986 taxation years, interest payable on both the advance and on the interest, that had previously become due and payable and had been capitalized, continued to be capitalized rather than being paid. Elections were made under subsection 78(1) of the Act for each of these years.
• As the result of an audit of the 1987, 1988 and 1989 taxation years of XXXXXXXXXX Part XIII tax was assessed with respect to the interest deemed to have been paid as a consequence of the subsection 78(1) elections.

Issue

Paragraph 3(e) of Article XI of the Convention provides an exemption for interest paid with respect to an obligation entered into before the date of the Convention (i.e. September 26, 1980), provided that such interest would have been exempt under Article XII of the 1942 Convention.

At issue is whether the amounts deemed to have been received by XXXXXXXXXX and loaned back to XXXXXXXXXX pursuant to subsection 78(1) of the Act represent new and separate obligations not eligible for the interest exemption under paragraph 3(e) of Article XI of the Convention.

Our comments

In our opinion, the application of subsection 78(1) of the Act has little or no bearing with respect to the issue at hand except to establish whether an amount was paid for the purposes of Part XIII of the Act.

It is our view that, unless the terms and conditions of the note (obligation) issued by XXXXXXXXXX to XXXXXXXXXX, as of the date of the coming into force of the Convention, specifically called for the capitalization of unpaid interest and, in effect, for the payment of compound interest, then a new obligation was entered into each year when a decision was made not to pay the interest due and payable that year. The occurrence of the latter, would be consistent with the taxpayer's claim for a Part I deduction each year with respect to the unpaid interest on the amount of unpaid interest previously capitalized.

In addition, it should be noted that a subsection 78(1) agreement may not be made with respect to unpaid interest which is compound interest. Subsection 78(1) of the Act only applies "...where an amount in respect of a deductible outlay or expense..." is unpaid at the end of the second taxation year following the taxation year in which the outlay or expense was incurred. Pursuant to the paragraph 20(1)(d) of the Act, compound interest is not deductible until actually paid.

We, therefore, feel that, as the taxpayer for the purpose of paragraph 20(1)(c) of the Act, was treating and continues to treat all of the interest payable each year as simple interest, which could only be the case if there existed new and separate obligations representing the interest due and payable each year and capitalized, that those same obligations are new and separate obligations for the purpose of paragraph 3(e) of Article XI of the Convention. The interest on such obligations when paid would not be exempt from Part XIII tax by virtue of paragraph 3(e) of Article XI of the Convention.

The simple interest due and payable on the amount outstanding at the time the Convention came into force, would, in our opinion, be exempt from Part XIII tax pursuant to paragraph 3(e) of Article XI of the Convention whether actually paid or deemed to have been as the result of an agreement made pursuant to subsection 78(1) of the Act.

We trust that our comments will be of assistance to you.

Roy Shultis
Acting Director General
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch