30 March 1999 Internal T.I. 9904437 - CSA, SDO, SUBVENTION 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:

1. Is the taxpayer a “restricted financial institution” (“RFI”) within the meaning of paragraph (e) of the definition in subsection 248(1)?

2. Is the taxpayer a “financial institution” as defined in subsection 142.2(1)?

3. Whether the income from conditional sales agreements (“CSAs”) acquired by the taxpayer constitutes income from specified debt obligations (“SDOs”)?

4. Whether the subvention payments received by the taxpayer constitute income from SDOs?

5. Whether the cost of a SDO would include allocated costs.

Position:

1. Yes.

2. Yes.

3. Yes.

4. No.

5. No.

Reasons:

1. This is a factual determination. Since the taxpayer’s principal business is to acquire CSAs which are debt obligations, it is a RFI.

2. Given that we consider the taxpayer to be a RFI, it follows that it is also a FI for SDO purposes pursuant to subparagraph (a)(i) of the FI definition in subsection 142.2(1).

3. Since the obligation under a CSA is a SDO, the income received on the CSA represents income from a SDO.

4. The subvention agreement between the manufacturer and the taxpayer and the CSA between the buyer and the taxpayer are two separate legal transactions.

5. The word “cost” is not defined in the Act. We have to look to the ordinary meaning of cost. In our view, absent a specific legislative provision to provide otherwise, the taxpayer’s cost of the SDO is limited to the purchase price paid or payable to the vendor of the SDO and would not include allocated costs incurred in the acquisition of the SDO. It is also our view that given the nature of the taxpayer’s business and the recent jurisprudence on running expenses, the allocated costs would likely constitute running expenses.

										March 30, 1999

XXXXXXXXXX TSO HEADQUARTERS
J. Leigh
Attention: XXXXXXXXXX (613) 952-1505
Large File Case Manager
990443

XXXXXXXXXX (“A Co”)

XXXXXXXXXX (“B Co”)

This is in reply to your memorandum of February 11, 1999, wherein you requested our comments with respect to various outstanding issues pertaining to the XXXXXXXXXX audit of A Co. These issues relate primarily to the specified debt obligation (“SDO”) rules provided for in sections 142.2 to 142.4 of the Income Tax Act (the “Act”).

As discussed in a recent telephone conversation (XXXXXXXXXX/Leigh), the first issue raised in your memorandum concerning the reserve for doubtful debts does not require our written comments. With regard to the last issue concerning unbilled subvention receivables, please refer to our memorandum of March 25, 1999 for our views on that issue. Our comments with respect to the other issues are as follows.

1. Restricted financial institution (“RFI”)

You advise that the principal business of A Co is to purchase conditional sales agreements (“CSAs”) from persons with whom A Co is dealing at arm’s length. XXXXXXXXXX Since the obligation under the CSAs constitutes a debt obligation, it is your opinion that A Co is a RFI within the meaning of the RFI definition in subsection 248(1) of the Act.

Pursuant to paragraph (e) of the RFI definition in subsection 248(1) of the Act, a RFI includes a corporation whose principal business is the lending of money to person with whom the corporation is dealing at arm’s length or the purchasing of debt obligations issued by such persons or a combination thereof. It is a factual determination whether a corporation meets either of these tests.

We have reviewed the copy of the sample CSA included with your referral. It is our view that the obligation under the CSA appears to have the characteristics of a note or similar obligation. In the case of CSAs, the promise to pay is not separately signed from the CSA but rather it is incorporated into the CSA. Therefore, we agree that the obligation under the CSA constitutes a debt obligation.

The CSA contains an assignment clause which provides that the seller sells, assigns and transfers to A Co his entire right, title and interest in the CSA and the property and A Co is authorized to do every act and thing necessary to collect and discharge the debt. There is no indication on the CSA that the assignment arrangement is actually a loan. You advise that the amounts due under the CSAs are recorded by A Co as receivables from the buyers. In our view, the assignment of the CSA by the XXXXXXXXXX to A Co results in a sale of the CSA to A Co.

Since you have determined that the principal business of A Co is to acquire CSAs from XXXXXXXXXX which deal at arm’s length with A Co, we concur that A Co is a RFI within the meaning assigned by paragraph (e) of the RFI definition in subsection 248(1) of the Act.

2. Financial institution (“FI”)

Given our view that A Co is a RFI, it follows that A Co is also a FI pursuant to subparagraph (a)(i) of the FI definition in subsection 142.2(1) of the Act.

We understand that A Co’s position is that it is not a FI for SDO purposes. Paragraph (e) of the FI definition in subsection 142.2(1) of the Act specifically excludes a prescribed person. A Co contends that it qualifies for this exclusion on the basis that it is a person prescribed by paragraph 8604(s) of the Income Tax Regulations (“Regulations”).

We disagree with A Co’s position as section 8604 of the Regulations prescribes corporations only for the purposes of paragraph (g) of the FI definition in subsection 181(1) of the Act. The fact that A Co is a prescribed corporation for Part I.3 purposes does not mean that A Co is a prescribed person for purposes of the SDO rules. Draft section 9000 of the Regulations lists the persons prescribed for the purposes of paragraph (e) of the FI definition in subsection 142.2(1) of the Act. Since A Co is not included in that list, it is not a prescribed person for that purpose.

3. Income from CSAs

You have asked us to confirm that income received on CSAs represents income from SDOs. You advise that at this time you have accepted that the income which has been reported is consistent with what would be reported from a SDO as required under the SDO rules.

The definition of a SDO in subsection 142.2(1) of the Act reads in part:

“specified debt obligation” of a taxpayer means the interest held by the taxpayer in

(a) a loan, debenture, mortgage, note, agreement of sale or any other similar indebtedness, or

(b) the interest held in a debt obligation where the taxpayer purchased the interest,

other than an interest in ...

In our view, the obligation under a CSA assigned to A Co can arguably fall under paragraph (a) or (b) of the SDO definition. Accordingly, unless one of the exclusions described in paragraph (c) or (d) of the SDO definition is applicable, it is our view that the obligation under the CSA constitutes a SDO with the result that A Co would have to compute its income from the CSA in accordance with the SDO rules. Where a taxpayer that is a FI holds a SDO, subject to subsections 142.3(3) and (4) of the Act, subsection 142.3(1) of the Act provides that the amounts to be included or deducted in computing income are the prescribed amounts in respect of the SDO.

4. Subvention payments

We understand that the interest rate charged to the buyer under the CSA is less than the market rate. The manufacturer, B Co, compensates A Co for accepting these low rate contracts. This payment is known as a “subvention payment”. From a business perspective, accepting these low rate CSAs only makes economic sense to A Co upon receipt of the compensating payment from B Co. In light of this, you have asked whether the subvention payment made by B Co to A Co would be considered income from a SDO.

You note that if the party making the subvention payment had been unrelated to the recipient, you might have considered the subvention payment to be income from a SDO. However, in this case, since A Co and B Co deal with each other at non-arm’s length, the subvention payment would not be income from a SDO by virtue of paragraph (d) of the SDO definition in subsection 142.2(1) of the Act. That paragraph excludes from the SDO definition instruments issued by or made with a person to whom the taxpayer is related or with whom the taxpayer does not otherwise deal at arm’s length, or in which the taxpayer has a significant interest.

It appears that your position is based on the premise that the subvention payment and the CSA may be viewed as a single transaction. While we agree that it would not make economic sense for A Co to accept these low rate CSAs without a compensating payment from B Co, we cannot ignore the fact that the subvention agreement between A Co and B Co and the CSA between A Co and the buyer are two separate legal transactions. As you will recall, in an earlier opinion (see E9506917 dated August 1, 1995), we concluded that the subvention payment did not have the characteristics of interest. B Co had not borrowed money from A Co and therefore it could not be said that the subvention payment represented compensation for the use of borrowed money. Arguably, the same logic would apply to the question of whether the subvention payment constitutes income from the related CSA. Accordingly, it would be difficult, in our view, to make the argument that the subvention payment represents income from a SDO. If we accept this reasoning, the fact that the subvention payment is made to A Co by an arm’s length party or a non-arm’s length party is not relevant in determining whether the subvention payment represents income from a SDO for tax purposes.

5. Loan origination costs

The expenses A Co incurs in connection with the acquisition of the CSAs are referred to as loan origination costs (“LOCs”). Such costs include direct costs such as finders fees as well as allocated costs related to salaries and wages, telephone, postage, freight, other office supplies and outside credit reports. For accounting purposes, LOCs are amortized over the life of the contract. You advise that this is consistent with AcG-4 issued by the CICA in October 1987 and SFAS No. 91. For tax purposes, we understand that only the allocated costs are deducted as incurred.

You have requested our views with respect to the treatment of the allocated costs under the SDO rules. In particular, you have asked whether such amounts would form part of the cost of the SDO. You note that if these costs are to be utilized in determining the yield from the SDO, they cannot be deducted in computing income under section 9 of the Act by virtue of paragraph 142.3(1)(c) of the Act.

We understand that A Co’s position is that the allocated costs are not referable to any particular item of revenue but are related to the whole of its business. Because such costs are not directly associated with any particular revenue item, the costs are bundled together and then analytically allocated to the contracts initiated in the year (based on authorized personnel headcount allocations for the various purchasing, review, and approval functions). A Co contends that salaries and wages and related overhead items are essentially fixed costs which are necessary to run the business and therefore should be fully deductible in the year incurred. A Co refers to the Supreme Court of Canada decision in Canderel Limited v. Her Majesty the Queen, 98 DTC 6100, as support for its position.

We note that the intent of the SDO rules is to require the taxpayer to include the total expected economic return from the SDO over the term of the SDO. If the cost of the SDO is increased by the allocated costs, the accrued return to be included in the income of the taxpayer will decrease.

The word “cost” is not defined in the Act. Therefore, we need to refer to its ordinary dictionary meaning and jurisprudence. In Black’s Law Dictionary (Sixth Edition), the word “cost” is defined as “expense; price. The sum or equivalent expended, paid or charged for something.” In Her Majesty The Queen v. Geoffrey Stirling, 85 DTC 5199, the Federal Court of Appeal held that “cost” as used in the capital gains provisions means the price that the taxpayer gave up in order to get the asset and that it did not include any expense that the taxpayer might have incurred in order to put himself in a position to pay that price or to keep the property afterwards.

We have looked at the meaning of “cost” as that word is used in former subsection 10(1) of the Act. After reviewing the relevant jurisprudence, we came to the conclusion that, in that context, cost is limited to actual laid out cost or the price paid for an asset. With regard to depreciable property, paragraph 8 of IT-285R2 states that the term “capital cost of property” generally means the full cost to the taxpayer of acquiring the property and includes legal, accounting, engineering or other fees incurred to acquire the property. While this position is logical in terms of capital property (particularly since the taxpayer is not entitled to a current deduction for such expenses), it is our view that we cannot apply it to the type of property under consideration here.

Absent a specific legislative provision to provide that the cost of a SDO includes certain adjustments, we have difficulty considering the allocated costs associated with acquiring the CSA as part of the cost of the SDO to A Co. In our view, the cost to A Co of the SDO would be the purchase price paid or payable to the vendor of the SDO. We note that we have confirmed with the Department of Finance that when the SDO rules were drafted, there was no discussion as to what items should or should not be included in cost. They were relying on the meaning of cost as used elsewhere in the Act and as established by jurisprudence.

If the allocated costs do not form part of the cost of the SDO, the next question is whether they should be amortized over the term of the obligation or deducted in the year incurred. This is a timing issue and, as noted in your memorandum, when we first considered the tax treatment of LOCs in 1992 (see E9216684A), we took the view that the timing of the deduction of LOCs that were directly related to a specific loan should generally be determined in accordance with GAAP unless a specific provision of the Act provided otherwise. However, in light of the recent jurisprudence on running expenses, it is appropriate to reconsider the treatment of LOCs at this time.

A running expense is an expense which is not referable to any particular item of revenue in the year of payment or in any subsequent year but is incurred in running the business as a whole. In Canderel, the issue was whether lease inducement payments made to induce tenants to enter into leases were fully deductible in the year incurred or had to be deducted over the terms of the respective leases. The Supreme Court found that the payments did not only result in a stream of income earned over the terms of the leases, but they also resulted in other less tangible benefits realized by the taxpayer in the year of payment. The Supreme Court concluded that the payments were running expenses to which the matching principle did not apply. In deciding this, the Supreme Court held that the goal of computing profit for income tax purposes is to obtain an accurate picture of the taxpayer’s profit for the year. It also held that profit computation is a question of law to be determined in accordance with the Act, jurisprudence and well-accepted business principles, which include but are not confined to GAAP. Further, if the Minister is to successfully challenge the taxpayer’s method of computing income for tax purposes, the onus is upon the Minister to show that his method produces a more accurate picture of income than the taxpayer’s method.

It is the Department’s position that the Canderel decision does not mean that all instances of lease inducement payments would be deductible up front. It remains a factual determination whether an expenditure is incurred for the specific purpose of earning an identifiable item of revenue which results in the application of the matching principle or whether there are sufficient current benefits from the expenditure to justify treatment as a running expense.

With regard to the allocated costs, the fact that A Co has amortized the allocated costs for accounting purposes does not necessarily mean that they should be amortized for income tax purposes. Consistent with our earlier opinion and AcG-4, it is our view that costs that are not directly associated with a particular obligation should not be amortized over the term of the obligation. As noted above, whether an item is directly associated with a particular obligation is a factual determination. Given the nature of A Co’s business and our understanding of the items included in allocated costs, in our view A Co has a respectable argument that the allocated costs are general business expenses incurred in the operation of A Co’s business. Accordingly, we are inclined to regard such costs as running expenses that are fully deductible in the year incurred for income tax purposes.

For your information, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Legislation Access Database (LAD) on the Department’s mainframe computer. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the LAD version or they may request a copy severed using the Privacy Act criteria which does not remove client identity. Requests for this latter version should be made by you to Jackie Page at (613) 957-0682. The severed copy will be sent to you for delivery to the client.

We hope that our comments are of assistance.

Manager
Financial Institutions Section
Financial Industries Division
Income Tax Rulings and
Interpretations Directorate
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