16 November 2010 External T.I. 2010-0374881E5 - Unpaid Amounts

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.

Principal Issues: Based on a hypothetical situation, which two companies are required to file the agreement under subsection 78(1)(b) and what is the correct withholding tax rate on the deemed interest paid to the non-resident company? In addition, is withholding tax payable when the interest is actually paid to another non-resident company that is fiscally transparent in the U.S.?

Position: The agreement is required to be filed with the same person that the expense was incurred. As a result, in this situation the withholding tax rate is 4 per cent for the 2009 year and the subsequent actual payment to the fiscally transparent entity is not subject to withholding tax.

Reasons: Paragraph 78(1)(b) requires the agreement to be made between the taxpayer and that person referred to in subsection 78(1), or the same person that the non-arm's length transaction occurred. Since the debtor is a U.S. resident corporation, paragraph 1 of Article XI of the Canada-U.S. Tax Convention reduces the withholding tax rate on the interest. The actual payment to the U.S. fiscally transparent entity is considered to be a repayment of a loan and is not subject to withholding tax.

XXXXXXXXXX 

									2010-037488
									A. Townsend

November 16, 2010

Dear XXXXXXXXXX :

Re : Interpretation of paragraph 78(1)(b) of the Income Tax Act

I am writing in response to your letter of July 12, 2010 asking for our views with respect to the application of paragraph 78(1)(b) in the situation you have described below.

All statutory references in this letter are references to the provisions of the Income Tax Act, R.S.C. 1985 (5th supp.) c. 1, as amended (the "Act").

The facts in your situation include the following details:

• Companies A, B and C are related and all have a taxation year end that is the same as the calendar year. Company A is a resident of Canada and is not fiscally transparent in the U.S. Company B is a resident of the U.S. and is not fiscally transparent in the U.S. Company C is a Limited Liability Corporation, is not resident of Canada and is fiscally transparent under the laws in the U.S.
• In Year 1, Company A borrows money from Company B and deducts an amount of interest in respect of this loan.
• During Year 2, Company B transfers the right to receive the loan and the accrued interest to Company C.
• During Year 4, Company A pays to Company C the amount of interest accrued on the loan during Year 1.

Based on these facts, you are asking for confirmation that Company A is required to file the agreement under subparagraph 78(1)(b)(i) with Company B; that the withholding tax rate will be 4% and that there will be no withholding tax payable when Company A actually pays the interest to Company C.

Written confirmation of the tax implications inherent in a particular transaction is given by this Directorate only where the transactions are proposed and are the subject matter of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R5, Advance Income Tax Rulings, dated May 17, 2002. Should your situation involve a specific taxpayer and a completed transaction, you should submit all relevant facts and documentation to the appropriate Tax Services Office for their views. However, we are prepared to offer the following general comments that may be of assistance.

Subsection 78(1) limits the accrual of deductible expenses, such as interest, owing by a taxpayer to a person (creditor) who was not dealing at arm's length with the taxpayer at the time the expense was incurred. Subsection 78(1) provides that if the expense is not paid by the end of the second taxation year following the end of the taxation year in which the expense was incurred, the amount of the expense is added to the taxpayer's income in the third taxation year. In order to avoid the income inclusion, paragraph 78(1)(b) allows the taxpayer and the creditor to file an agreement to treat the unpaid amount as if it were in fact paid on the first day of the third taxation year and was replaced on the same day by a loan of equal amount (less applicable withholding taxes).

Paragraph 78(1)(b) requires the agreement to be filed by "...the taxpayer and that person with whom the expense was incurred...." In your situation, the unpaid amount is an interest expense for Year 1 owed from Company A to Company B. Therefore, based on the wording in paragraph 78(1)(b), the agreement must be filed between the taxpayer (Company A) and that person (Company B).

If an agreement is filed under paragraph 78(1)(b), the interest payment will be deemed to be paid to Company B on the first day of Year 4. Company B is a related U. S. resident that is not fiscally transparent in the U.S. Therefore, the Canada-U.S. Tax Convention will apply and the reduced withholding tax rate applicable to Year 4 will apply to the deemed interest payment. Any subsequent payments made on account of the deemed paid interest are regarded as the deemed loan repayments and are not subject to non-resident withholding tax.

We trust these comments are helpful.

Yours truly,

Guy Goulet CA, M.Fisc.
for Acting Director
Ontario Corporate Tax Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch