25 November 1998 CTF Roundtable, 9823880 - CTF - TAX CASES - SHERWAY CENTRE

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: Impact of Sherway decision

Position: Depends on the facts of a particular case

Reasons: na

Recent Cases
Revenue Canada Round Table
Canadian Tax Foundation Conference
October 1998

Sherway Centre Limited
Federal Court of Appeal
February 5, 1998

Issue:

Whether the additional payments on bonds are deductible in computing income.

Law:

Paragraph 20(1)(c) of the Income Tax Act allows a deduction for interest where it is paid pursuant to a legal obligation. However, Act does not define the term interest. The Act also provides for a deduction for expenses incurred in the course of borrowing money under paragraph 20(1)(e) if they are not otherwise deductible.

Facts:

Bonds were issued in 1971 at a stated rate of interest of 9.75%. The bonds also provided for additional interest payments, commonly referred to as “participation payments”, computed as a percentage of yearly adjusted operating surplus. The yearly additional payment was not limited to a stated percentage of the outstanding amount owing on the bonds.

Department’s Position:

The Department’s longstanding published position is that a participation payment is interest provided that:

• the payment is limited to a stated percentage of the principal;
• the limiting percentage reflects the commercial interest rates prevailing between arm length’s parties at the time the loan is entered into; and
• no other facts indicate the presence of an equity investment.

Judgment:

The Federal Court of Appeal dismissed our appeal and found that the additional interest payments were deductible either as interest or as expenses incurred in the course of borrowing money.

The Court found that the additional interest payments were interest for the following reasons:

• they represented compensation for the use of borrowed money;
• together with the stated rate portion, they reflected the prevailing commercial rate of interest on the bonds at the time they were issued;
• they accrued day to day; and
• they were referable to the outstanding principal amount.

The Court also found that the additional interest payments were expenses incurred in the course of borrowing money because they were “in connection with,” “incidental to,” or “arising from” the borrowing as had been held by the Federal Court of Appeal in the case of Yonge-Eglinton Building Limited, 74 DTC 6180.

Impact of the Decision:

In response to a question from the Tax Executives Institute asking for the Department’s position with respect to the tax treatment of participating loan payments in light of this decision, we stated:

With respect to the treatment of such payments as interest under paragraph 20(1)(c), our position has been that in order to qualify as interest, participating loan payments must be limited to a stated percentage of principal, the limiting percentage must reflect commercial interest rates prevailing at the time the loan is entered into, and no other facts can indicate the presence of an equity investment.

Although the participating loan payments in Sherway did not meet these criteria, in our view the Court’s ruling amounted to a factual determination in that all of the documents and the evidence presented in Court indicated that the participating loan payments were intended to increase the yield on the loan to the prevailing market rate.

Therefore, although we do not intend to change our current position, where participating loan payments do not satisfy all the criteria mentioned above but there is clear evidence that the payments are paid in lieu of interest, as for example where they are intended to increase the interest rate of a loan to the prevailing market rate, we will allow the deductibility thereof as interest under paragraph 20(1)(c) of the Act. If, however, the payments are such that they result in the yield on the loan exceeding the prevailing market rate and the evidence establishes that the parties did not genuinely attempt to estimate whether the payments would approximate this rate, we might deny the deduction of the participating loan payments under paragraph 20(1)(c) of the Act on the grounds that they are distributions of profit and not interest.

With respect to the deductibility of such payments under paragraph 20(1)(e) of the Act, since the Court allowed the payments to be deducted under paragraph 20(1)(c) of the Act and dealt only incidentally with paragraph 20(1)(e), we do not believe that any change to our views that such payments are not deductible under paragraph 20(1)(e) of the Act is required at this time.

B. Kerr
982388
September 14, 1998