3 May 1985 Income Tax Severed Letter RRRR103 - Treatment of participation payments under U. S. Treaty

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.

MEMO TO FILE
FINANCE & LEASING SECTION

Reference: Paragraph 212(1)(d) of the Income Tax Act Canada-U. S. Income Tax Convention (1980) - Articles VI, XI.

Subject: Treatment of participation pyments under U. S. Treaty

Problem:

A particular corporation ("Canco") is proposing to issue a deby instrument in the United States to certain parties which are expected to be institutional investors. It is proposed that the instrument have two principal amounts (evidenced by two notes) each of which is subject to specific repayment terms, interest and term ot maturity. It is in regard to the return on one of these notes that the contentious issues have arisen. Briefly, the note in question (the "variable rate note") bears a variable return calculated with reference to the issuer's gross revenue in respect of certain oil and gas wells the drilling of which will commence after the issue of the instrument. Accordingly, it is possible to view this return both as a gross overriding royalty in respect of the above-noted wells and as compensation to the lender in lieu of interest. This latter view becomes more persuasive when one considers that the variable rate note is to be issued simultaneously with another higher principal note bearing a fixed rate of interest ("Fixed rate note"), which rate would have to be much higher if the two notes were to be combined and carry one rate of interest. The variable rate note might therefore be viewed as an adjunct to the fixed rate note whose purpose is to enable the marketing of that latter note.

Issues:

• 1. What is the appropriate treatment of the variable return under the Income Tax Act?
• 2. Whether the variable return is to be regarded as income derived from real property under article VI of the U.S. Treaty or alternatively as interest under article XI of that treaty.

Discussion:

• 1. although the variable return can be categorized as compensation to the lender in respect of borrowed money, it is not computed by reference to that obligation and therefore does not come within the legal definition of interest. The return is more appropriately treated as a royalty in respect of the wells to which it relates.
• 2. As a royalty the variable return is computed by reference to the amount or value of production from oil wells and therefore is properly regarded as income derived from real property under Article VI. However, it is also possible to regard the variable return as income from a loan that carries a right to participation in the revenue of the debtor and thus as interest under Article XI. However, given that real property is defined in paragraph 2 of Article VI for the purposes of the convention as a whole while the definition of interest is restricted in its applicability to Article XI, it appears that Article VI should take precedence in this situation. Furthermore, we have been advised by the Department of Finance that in policy terms the variable return should be treated as income from real property and should be treated as income from real property and a not as interest.

Positions:

• 1. The variable return is a royalty which is deductible to the corporation and subject to Part XIII tax by virtue of paragraph 212(1)(d) of the Income Tax Act.
• 2. The variable return is to be regarded as income derived from real property and thus subject to Article VI of the Canada - U.S. Income Tax Convention (1980).