5 January 1996 CTF Roundtable Q. 31, 9523976 - GROSS-UP PAYMENTS

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.

Principal Issues:

The principal issue is the taxability of an amount described as "gross-up interest" on loans with non-residents. Specifically, are gross-up amounts when paid by a financial institution such as a bank to a non-resident directly, or paid on the non-resident's behalf under Part XIII, deductible as interest under paragraph 20(1)(c); section 9; or alternatively, as an ECE. Further when gross-up amounts are received by a Canadian bank from a non-resident, or indirectly received from a non-resident (ie. as a payment by the non-resident to his home country as a withholding tax) are these amounts taxable under section 9, paragraph 12(1)(c) or some other section?

Position:

See response for details - depends on facts - amounts received will be taxable as income.

Reasons:

See response

			January 5, 1996

	HEADQUARTERS	HEADQUARTERS
	Large Business Audit	Michael Cooke
(613) 957-3498
	Attention:  Blair Chisholm
	              Industry Specialist Services

952397

Gross-up Loans

This is in reply to your memorandum of September 7, 1995, concerning the income tax treatment of certain payments made or received by Canadian banks on "gross-up" loans. You have defined a gross-up loan as being one where the interest paid by a borrower is increased (the gross-up) to account for any non-resident withholding taxes. Your questions relate to the potential application of this Directorate's views on this matter, as expressed in a technical interpretation #E9404605 dated October 18, 1994, where Canadian banks are involved in international borrowing and lending. We apologize for the delay in our response.

Deductibility of Gross-up Payment

Generally, costs incurred in connection with financing, including interest, represent expenditures on account of capital and are subject to the limitation under paragraph 18(1)(b) of the Act unless the taxpayer is engaged in the business of lending money and the financing is on income account (ie. stock in trade). The characterization of any gross-up as interest, the legal definition of which in this country is very narrow, is a question of fact and will depend on the wording of the particular loan agreement. Accordingly, the facts and circumstances of a particular situation would have to be examined to determine whether the gross-up would be deductible, in whole or in part, under the Act.

Where the gross-up meets the legal definition of interest then it would be deductible by a taxpayer under paragraph 20(1)(c) of the Act, assuming the other conditions of that paragraph were met and no other section of the Act applied to limit that deduction. However, where the gross-up does not meet the legal definition of interest and is not deemed to be interest for the purpose of paragraph 20(1)(c), the amount will not be deductible under that paragraph.

As stated in the aforementioned technical interpretation, paragraph 20(1)(e) of the Act would not apply to permit a deduction for the gross-up where the amount represents compensation for the use of borrowed money. That technical interpretation also stated that a gross-up may represent an eligible capital expenditure ("ECE") where it meets the definition of ECE in subsection 14(5) of the Act. In order for such a payment to qualify as an ECE the expenditure must be made for the purpose of earning income from the taxpayer's business, and no other provision exists in the Act that would provide for a current deduction or amortization of the expenditure. Moreover, the amount must not be otherwise specifically excluded from the definition of ECE. Given that such a determination as it relates to gross-up loans would ultimately depend on the facts and circumstances of a particular situation we are unable to confirm that ECE treatment is appropriate with respect to a gross-up.

However, as noted above, where the taxpayer is engaged in the business of lending money and the financing is on income account the gross-up will be deductible as an ordinary business expense under section 9 of the Act.

Inclusion of "Gross-up" Amounts in Income

It is our view that where a gross-up on a debt obligation is either received or receivable by a Canadian lender the gross-up would be required to be included in the taxpayer's income under either section 9 or pursuant to paragraph 12(1)(c) of the Act. This would also be the case where the gross-up is paid or credited to the government of a foreign country on the Canadian lender's behalf since the Canadian lender would have constructively received the gross-up. One would also have to consider the application of the interest accrual rules where the debt obligation is a prescribed debt obligation.

Part XIII Issues

For Part XIII purposes, where a gross-up is paid or credited by a Canadian resident to a non-resident pursuant to a loan agreement the gross-up is subject to withholding unless interest payments under the debt obligation are otherwise exempt. This withholding is generally required whether or not the gross-up meets the legal definition of interest because the preamble to paragraph 212(1)(b) of the Act refers to amounts paid or credited, "as, on account or in lieu of payment of, or in satisfaction of, ... interest". In our view this broader wording encompasses a gross-up since it generally represents compensation for the use of borrowed money notwithstanding the fact that it may otherwise lack one or more of the other qualities of legal interest.

In regard to your question as to whether situation II of the technical interpretation should differ from situation I we offer the following general comments.

Generally, the Department is of the view that withholding tax should be calculated as set forth in Round Table question 31 of the 1993 CTF Conference Report. For example, in situation II as set out in the technical interpretation you referred to, it is our view that the calculation of withholding tax would be no different from that of situation I. The Canadian resident borrower has by agreement, ensured that the non-resident lender will receive the full amount of the interest free of any withholding tax. Therefore, it is our view that the gross-up would be considered an amount paid or credited as, on account or in lieu of payment of, or in satisfaction of, interest and subject to withholding.

As we have noted the income tax implications are dependent upon the terms of a particular agreement. Should you wish us to review a specific situation that you are concerned would not be covered by the Round Table question referred to above we would be happy to do so.

F. Lee Workman
Section Chief
Financial Institutions Section
Financial Industries Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch