2 May 1984 Income Tax Severed Letter A-9510

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.

Dear Sirs:

This is in reply to your letter of March 22 requesting various opinions with respect to the exemption set out in paragraph 212(1)(b)(vii) of the Income Tax Act (the "Act").

• 1. Single Debt Issue

You cite a hypothetical situation whereby a Canadian corporation seeks to borrow funds from a group of lenders consisting of both residents and non-residents. The borrower would issue, at the same time, a number of obligations that are identical with respect to most of their terms. However, the group of obligations issued to non-resident lenders would have a 5 year term while the group issued to Canadian lenders would be payable on an earlier date or on demand.

Our Comments

It is our view that two such groups of obligations would not comprise "a single debt issue of obligations that are identical in respect of all rights attaching thereto" for purposes of subparagraph 212(1)(b)(vii) of the Act.

• 2. Interest on an Obligation

For purposes of subparagraph 212(1)(b)(vii) of the Act, it is our view that "interest payable on an obligation" would include interest payable by the borrower on the obligation after the occurrence of an event of failure or default. It would also include interest on overdue interest with respect to the obligation.

• 3. Payable By

Generally speaking, interest "payable by" a Canadian corporate borrower for purposes of paragraph 212(1)(b)(vii) of the Act would in our view include an amount paid by a third party on behalf of the borrower on account of, in lieu of payment of, or in satisfaction of interest owing by or due from the borrower.

• 4. Component Conversion

You cite a situation whereby a non-resident lender may provide that the Canadian corporate borrower can draw down funds in more than one currency although the amount outstanding is on the loan and the repayment obligations of the borrower are usually denominated in one currency.

Similarly, a loan may provide for more than one interest rate formula where the borrower desires a floating rate and the non-resident lender has access to more than one market source of funds. For example, the rate may be based on LIBOR. General, the LIBOR rate in effect from time to time reflects the non-resident lender's cost of funds, and the borrower will be charged a rate expressed as LIBOR plus a spread. Alternatively, the rate payable by the borrower may be based on the prime commercial lending rate charged by the lender in its own jurisdiction. In addition, the applicable rate may vary depending on the currency in which the loan is denominated, reflecting in part market expectations of exchange rate risks.

For debt administration reasons, in circumstances where a single loan may relate to multiple currencies or interest rate formulae, each permissible permutation is treated as a separate component of the loan. Since the circumstances that determine the choice of one or more components at the time the loan is made may change prior to maturity of the loan, the loan agreement will often permit the borrower to "convert" all or a portion of one type of component of the loan into another type of component. The loan agreement will also usually entitle the lender to compel a component conversion where a change in circumstances adversely affects the lender or makes the continued maintenance of such component no longer practical. The mechanism for making a component conversion and the effects thereof would be set out in the loan agreement. A conversion is accomplished by "bookkeeping" entities which transfer the amount outstanding from one component to the other component. Accordingly, the borrower is not required to make any cash payment to the lender in respect of the former component and the lender does not advance any new funds in respect of the new component.

Our Comments

Generally speaking, component conversions such as that described above and initiated by the borrower will not represent repayment of all or part of the loan, or as the making of a new loan, for purposes of the "5 year rule" set out in paragraph 212(1)(b)(vii) of the Act. However, we are not prepared to express the same general opinion where the conversion is dictated by the lender. Rather, we will express our views with respect thereto only on a case by case basis.

• 5. Obligation to Pay Principal

You comment that where the loan agreement provides for repayment of part of the principal amount thereon during the first 5 years of the loan, there are frequently difficulties with respect to determining in advance whether the repayment obligations will comply with the 25% rule in subparagraph 212(1)(b)(vii) of the Act. In these circumstances, the agreement will usually contain a provision that overrides and negates the borrower's repayment obligations with respect to any portion of a payment of principal that would violate the 25% rule. However, in order to protect the position of the lender, the loan agreement will often also provide that the portion of the repayment that would otherwise have been required to be made (a "deferral amount") must be deposited by the borrower in a special cash collateral account maintained by it with a depository and made subject to a lien in favour of the lender. Amounts deposited in such account belong to the borrower but may be invested only in approved high quality securities. Any revenue derived from such account will belong to the borrower, but may only be withdrawn if the borrower is not otherwise in default in respect of the loan. The borrower may occasionally use the funds in this account to make optional prepayments of principal and will generally be required to use the remaining funds in such account after the fifth anniversary of the loan to pay to the lender an amount equal to the aggregate of the deferred amounts less deferred amounts that have been previously prepaid on an optional basis.

Our Comments

We are not prepared to express a general opinion that payments to a third party trustee or depository will not be considered to represent obligatory payments by the borrower on the principal portion of the loan. Rather, we will express our views with respect thereto only on a case by case basis.

• 6. Failure or Default

You mention that subparagraph 212(1)(b)(vii) of the Act permits repayments of principal without limitation within 5 years of the date of issue of a non-resident loan "in the event of a failure or default under the (said) terms of agreement" of the obligation. This exception does not appear to be limited to any particular types of failure or default and, in current loan agreements, it is common to find several pages of events or occurrences that are defined to constitute "events of default". Such events will include failures or defaults by the borrower in fulfilling its obligation with respect to the non-resident loan and will also generally include failures or defaults by the borrower with respect to its other obligations and the occurrence of specified events to the borrower, any of which could impact on the borrower's ability to meet its obligations with respect to the non-resident loan. It is understood that bona fide events of default of this nature which are beyond the control of the non-resident lender are acceptable to Revenue Canada. However, in some circumstances where a borrower is a member of a group of affiliated corporations, a non-resident lender may make a loan to the borrower on terms which would otherwise only be offered to a more substantial member of the corporate group on the basis of the creditworthiness of such member. The lender may require the affiliated corporation to provide it with a guarantee of the borrower's obligation. However, the lender may not require such guarantee where the amount of the loan is small in relation to the volume of business it transacts with the associated corporation and, in this case, the lender will rely on its relationship with the associated corporation and that corporation's business reputation. In these situations, whether or not the associated corporation provides a guarantee, security or other legal recourses to the lender, the loan agreement will usually include events of default relating to the creditworthiness of the associated corporation and to any change in its association with the borrower. For example, where the associated corporation is the parent of the borrower, the bankruptcy of the parent or a sale by the parent of interest in the borrower would normally constitute events of default. Although a lender may not have legal recourse against the associated corporation, its ability to stand behind the borrower and the existence of other business relationships between the lender and this corporation would generally constitute a significant inducement to the lender to make the loan on favourable terms. Any change in these circumstances would accordingly be regarded by the lender as an indication of a significant increase in the risk of default by the borrower with respect to its obligations under the loan.

Our Comments

The words "events of a failure of default under the said terms of agreement" set out in subparagraph 212(1)(b)(vii) of the Act recognize the need for the lender to protect his loan and, in this regard, include any event which places one of the parties in breach of the conditions he undertook to perform or the guarantees he gave in the agreement. Thus, if the borrower fails to meet the repayment program or undertakes actions which materially increase the lender's risk, the lender may demand repayment in full. For example, non-compliance with credit covenants may constitute an event of default, enabling the lender to accelerate payments.

In relating this general position of the Department to types of events of failure or default referred to above in your comments, it is our view that they would represent legitimate events of failure or default for purposes of subparagraph 212(1)(b)(vii) of the Act. We assume of course that any covenants given by the borrower would be commercially realistic and that it would be reasonable to expect, at the time the loan agreement is entered into, that they can be maintained throughout the term of the loan.

• 7. Compensation and Indemnity Payments

You comment that where the terms of a loan agreement contemplate that the lender is entitled to make a fixed net return in respect of the loan, the agreement will usually contain provisions which require the borrower to compensate the lender when subsequent events affect the net return to the lender. Such payments include:

• (i) Additional costs - Compensation for cost increases or reductions in amounts receivable in respect of the loan attributable to subsequent changes in government regulatory or tax legislation, such as modifications to reserve requirements or restrictions on certain categories of liabilities or assets which the lender may hold.
• (ii) Broken funding - Since the lender may fix its cost of funds with respect to the non-resident loan by borrowing an equivalent amount from time to time for a period equivalent to the period during which the interest ate on the loan is fixed (an "interest period"), the borrower must compensate the lender for any loss, cost or expense incurred by the lender as a result of any payment, prepayment or conversion of any portion of the non-resident loan on a date other than the last date of the interest period for such portion or for any such costs resulting from any failure by the borrower to borrow any portion of the loan on the date specified therefore.
• (iii) Government taxes and other charges - The borrower is required to make compensation payments to the lender to enable the lender to receive, after the deduction of any government taxes, charges or related amounts, including interest and penalties, the amount originally specified to be receivable on account of principal and interest in respect of the loan.

Our Comments

Whether such compensation or indemnification payments represent interest is a question of fact which can only be determined by reviewing all related documentation. However, should such payments factually represent interest or be deemed to be interest under a particular section of the Act, such interest or deemed interest would be exempt from Part XIII tax if the interest stated to be payable on the loan was itself exempt from Part xIII tax pursuant to subparagraph 212(1)(b)(vii) of the Act.

• 8. Expenses

You comment that a lender will normally require the borrower to pay or reimburse the lender for the reasonable fees and expenses incurred by the lender (including reasonable counsels' fees) in connection with the preparation of the loan documentation and the making of the loan, including the perfection of security interests, any subsequent modifications to any terms of the loan and costs and expenses in connection with the enforcement of the loan obligations.

Our Comments

Generally speaking, such payments or reimbursements would constitute neither interest nor management fees for purposes of the Act and thus, they would not be subject to Part xIII tax.

We trust the above comments are satisfactory for your purposes.