1 December 1998 Internal T.I. 9829850 - PARTICIPATING PAYMENTS - INTEREST

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.

Tax Executive Conference

Question XVII Participating Payments - Interest

Question

In Sherway Centre, 98 DTC 6121, the Tax Court adopted a much broader view than Revenue Canada concerning the deductibility of participating payments as interest. We believe that the decision is well reasoned and reflects commercial reality because it significantly narrows the gap between the legal and economic concepts of interest, which, in the absence of modernized legislation addressing the proper tax treatment of financing costs, is welcome news for the business community. In its decision, the court set forth three factors to be considered in determining whether a participating payment is deductible as interest, specifically the amount payable must -

- Be considered compensation for the use of money;

- Reference a principal amount; and

- Accrue on a day-to-day basis.

Hence, while the approach is workable, application of the test to instruments that are similar though not identical, to that in Sherway Centre is uncertain primarily because it is unclear whether Revenue Canada accepts the court’s enunciated test. In light of the uncertainty, would Revenue Canada clarify its position in respect of the deductibility of participating payments? Has Revenue Canada modified its assessing position in light of the decision?

Prior to the decision in Sherway Centre, one could argue, based on Revenue’s Canada’s previous position that, since participating payments were not interest, then unlike the regular or periodic interest payments that might also be made to non-residents under the instrument, the participating payments were eligible for the withholding tax exemption under 212(1)(b) because the participating payments were not governed by the postamble of paragraph 212(1)(b) (which only addresses interest computed by reference to revenue, profit, etc.). If the participating payment amounts are now considered interest, however, the payments will likely be subject to withholding tax. What is Revenue Canada’s position on this matter with respect to debt instruments outstanding at the time of the Sherway Centre decision or issued subsequently?

DEPARTMENT’S POSITION

With respect to the treatment of participating loan 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.

The judgment in Sherway dealt with the existing jurisprudence on interest and found as a determination of fact that the participation payments were interest. To the Department, the critical reason was that the sum of the stated interest and the participation payments approximated the commercial rate of interest at the time the bonds were issued.

Therefore, the Department is of the opinion that the Sherway decision helps to distinguish between those financial arrangements where the participation payments are intended to be interest as evidenced by an attempt to reflect the prevailing rate of interest and those arrangements where the participating payments are structured to be in reality a distribution of profit. The Department continues to maintain that profits should be taxed before they are distributed.

While the Sherway decision has caused the Department to expand our published position, it does not stand for the proposition that all participating payments are considered interest. Our long-standing criteria is based on jurisprudence and we believe it is still an appropriate method of determining whether an amount is interest. However, as stated, we believe the Sherway decision involved a factual determination in that all of the documents and the evidence presented to the Court showed that the participating loan payments were intended to increase the yield on the loan to the prevailing market rate. Therefore, to maintain a measure of certainty in this area, taxpayers can continue to rely on our published criteria for determining when participating loan payments are considered as interest. Where all the published criteria are not satisfied but the evidence shows, as it did in Sherway, that the participation payments are intended to increase the interest rate on the loan to the prevailing market rate, we will consider the payments to be interest under paragraph 20(1)(c) of the Act.

Paragraph 212(1)(b) of the Act imposes non-resident withholding tax on amounts paid or credited by a person resident in Canada to a non-resident, on account of, in lieu of payment of or in satisfaction of, interest. Subparagraphs 212(1)(b)(i) through (xii) provide exceptions from the rule. The postamble to paragraph 212(1)(b) removes the exemptions contained in subparagraphs 212(1)(b)(ii) to (vii) and (ix) for interest payable on an obligation where all or any part of the interest is computed by reference to revenue, profits, cash flow, commodity prices or any other similar criterion or by reference to dividend payments.

Accordingly, in our opinion, where an obligation issued to a non-resident provides for participation payments that are, following the reasoning above, considered to be interest payments, the postamble in paragraph 212(1)(b) will be applicable such that no exemption from withholding tax will be available for any interest payment made after the date of the Sherway decision (Feb 5, 1998). However, the Department will not reassess for withholding tax on interest payments made prior to the Sherway decision provided that any participation payments made in those periods were and are not claimed as interest expenses or otherwise capitalized.

982985