2005 Ruling 2005-0145911R3 - Interest deductibility

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: Whether 212(1)(b)(vii) applies

Position: Yes.

Reasons: Previous decisions.

XXXXXXXXXX 						2005-014591

XXXXXXXXXX, 2005

Dear XXXXXXXXXX:

Re: XXXXXXXXXX
XXXXXXXXXX
Advance Income Tax Ruling

We are writing in response to your letter of XXXXXXXXXX, wherein you requested an advance income tax ruling on behalf of the above taxpayers.

To the best of your knowledge and that of the taxpayers involved, none of the issues contained in this ruling request are:

(i) dealt with in an earlier return of the taxpayers or a related person;

(ii) being considered by a tax services office or taxation centre in connection with a previously filed tax return of the taxpayers or a related person;

(iii) under objection by the taxpayers or a related person;

(iv) subject to a ruling previously issued to the taxpayers or a related person by the Income Tax Rulings Directorate; or

(v) before the courts or, if a judgment has been issued, the time limit for appeal to a higher court has not expired.

DEFINITIONS

In this letter, the following terms have the following meanings:

(a) "Act" means the Income Tax Act, R.S.C. 1985 (5th Suppl.) c.1, as amended to the date hereof. All statutory references in this letter are to the Act, unless stated otherwise;

(b) "Business" means the business of X LP. The Business involves the development, acquisition, investment in and conduct of the business, ownership, operation and lease of assets and property in connection with the XXXXXXXXXX business in Canada, together with all activities ancillary or incidental thereto. XXXXXXXXXX;

(c) "Canadian Bank" means XXXXXXXXXX;

(d) "Change in Control" means, under the Note Purchase Agreement, inter alia, an event or transaction that results in Z Co ceasing to hold at least XXXXXXXXXX% of all limited partnership units of X LP, or ceasing to be the largest beneficial holder of such limited partnership units, other than the Trust;

(e) "CRA" means the Canada Revenue Agency;

(f) "Credit Agreement" means the agreement to be entered into between Y Co and Canadian Bank outlining the terms and conditions of the Revolving Facility;

(g) "Existing Term Facility" means the current $XXXXXXXXXX, XXXXXXXXXX-year, non-revolving, term facility of X LP, established pursuant to an agreement dated XXXXXXXXXX, as more fully described in Paragraph 9;

(h) "Fund" means XXXXXXXXXX, an inter vivos trust established under the laws of the Province pursuant to a Declaration of Trust dated XXXXXXXXXX, as amended;

(i) "Governance Agreement" means the agreement between X Co, the Trust and Z Co (formerly between X Co, the Trust and Z LP) dated XXXXXXXXXX, as described in Paragraph 7;

(j) "Group" means the XXXXXXXXXX, the members of which are X Co, X LP and its subsidiaries, if any, the Trust and the Fund;

(k) "Individual" means XXXXXXXXXX, Director, Chairman and Chief Executive Officer of X Co;

(l) "Initial Draw" means the borrowing evidenced by Term Notes having an aggregate principal amount equal to US$XXXXXXXXXX (or the Canadian dollar equivalent) to be issued by Y Co to the Term Lender under the New Term Facility on the closing date of the New Term Facility;

(m) "LP Initial Amount" means US$XXXXXXXXXX (or the Canadian dollar equivalent) to be advanced by Y Co to X LP pursuant to the Sub-Loan Agreement using the funds received from the Initial Draw obtained by Y Co under the New Term Facility;

(n) "Mutual Fund Trust" has the meaning assigned by subsection 132(6) of the Act;

(o) "New Term Facility" means the "shelf" credit facility of up to US$XXXXXXXXXX (or the Canadian dollar equivalent) to be provided to Y Co by the Term Lender pursuant to the Note Purchase Agreement;

(p) "Note Purchase Agreement" means the Note Purchase and Private Shelf Agreement to be entered into between Y Co, X Co and the Term Lender outlining the terms and conditions of the New Term Facility and the Term Notes, and pursuant to which the Term Lender agrees to purchase the Term Notes of Y Co;

(q) "Paragraph" means a numbered paragraph in this advance income tax ruling;

(r) "Proposed Transactions" means the transactions described in Paragraphs 12 to 25;

(s) "Province" means the Province of XXXXXXXXXX;

(t) "Revolving Facility" means the revolving credit facility of at least CDN$XXXXXXXXXX to be provided to Y Co by Canadian Bank pursuant to the Credit Agreement;

(u) "Special Voting Units" means special voting units of the Fund, as described in Paragraph 5;

(v) "Sub-Loan Agreement" means the agreement to be entered into between Y Co and X Co, in its capacity as general partner of X LP, outlining the terms and conditions relating to the LP Initial Amount, and such further amounts as may from time to time be advanced by Y Co to X LP with future draws obtained by Y Co under the New Term Facility or the Revolving Facility;

(w) "taxable Canadian corporation" has the meaning assigned by subsection 89(1) of the Act;

(x) "TC" means Taxation Centre;

(y) "Term Lender" means XXXXXXXXXX., a corporation incorporated under the laws of XXXXXXXXXX and a non-resident of Canada for purposes of the Act, or one or more of its affiliates, as defined in the Note Purchase Agreement, each of which is a non-resident of Canada for purposes of the Act;

(z) "Term Notes" means notes having a maximum aggregate principal amount of US$XXXXXXXXXX (or the Canadian dollar equivalent) to be issued by Y Co to the Term Lender pursuant to the Note Purchase Agreement which evidence the indebtedness of Y Co to the Term Lender under the New Term Facility;

(aa) "Trust" means XXXXXXXXXX, an inter vivos trust established under the laws of the Province pursuant to a Declaration of Trust dated XXXXXXXXXX;

(bb) "TSO" means Tax Services Office;

(cc) "Units" means units of the Fund as described in Paragraph 5;

(dd) "Unit Trust" has the meaning assigned by paragraph 108(2)(a) of the Act;

(ee) "US" means United States of America;

(ff) "X Co" means XXXXXXXXXX., a corporation incorporated under the Canada Business Corporations Act. The head office of X Co is located at XXXXXXXXXX. The business number of X Co is XXXXXXXXXX and it is located within the area served by the XXXXXXXXXX TSO and the XXXXXXXXXX TC;

(gg) "X LP" means XXXXXXXXXX, a limited partnership formed under the laws of XXXXXXXXXX and governed by the X LP Agreement. The head office of X LP is located at XXXXXXXXXX. The Business Number of X LP is XXXXXXXXXX and it is located within the area served by the XXXXXXXXXX TSO and the XXXXXXXXXX TC;

(hh) "X LP Agreement" means the amended and restated limited partnership agreement dated XXXXXXXXXX, as amended, which governs X LP;

(ii) "X LP Guarantee" means the agreement or agreements to be entered into by X Co, X LP, the Fund, and the Trust, with the Term Lender and Canadian Bank, respectively, pursuant to which a guarantee will be provided by each of X Co and X LP, and a limited recourse guarantee will be provided by each of the Fund and the Trust, in favour of the Term Lender and Canadian Bank of the obligations of Y Co under the Term Notes and under the Revolving Facility, respectively;

(jj) "Y Co" means a corporation to be formed under the Business Corporations Act (XXXXXXXXXX) as a direct, wholly-owned subsidiary of X Co;

(kk) "Z Co" means XXXXXXXXXX., a corporation incorporated under the Business Corporations Act (XXXXXXXXXX ), and

(ll) "Z LP" means XXXXXXXXXX, a limited partnership formed under the laws of the Province, wholly-owned by Z Co and affiliates of Z Co, which was wound up on XXXXXXXXXX.

Our understanding of the Facts and Proposed Transactions is as follows:

FACTS

1. X Co is a taxable Canadian corporation and was formed on XXXXXXXXXX to act as the general partner of X LP. The only issued and outstanding share capital of X Co consists of a single class of voting common shares, of which the Trust owns approximately XXXXXXXXXX% and Z Co owns the remaining XXXXXXXXXX%.

2. X LP is a limited partnership formed under the laws of XXXXXXXXXX, the sole general partner of which is X Co. X LP has issued and outstanding general partnership units, ordinary limited partnership units, exchangeable limited partnership units, and subordinated limited partnership units. All of the general partnership units issued by X LP are owned by X Co. All of the ordinary limited partnership units issued by X LP, representing approximately XXXXXXXXXX% of all issued and outstanding limited partnership units of X LP, are owned by the Trust. All of the issued and outstanding subordinated and exchangeable limited partnership units issued by X LP are owned by Z Co, which units represent the remaining XXXXXXXXXX% limited partnership interest in X LP.

3. The Trust is a Unit Trust and is not a Mutual Fund Trust. The Fund is the sole beneficiary of the Trust and currently holds all indebtedness issued by the Trust in the form of interest-bearing Series 1 unsecured subordinated demand notes of the Trust. The Trust is a limited purpose trust and its activities are restricted to conducting, directly or indirectly through its ownership of common shares of X Co and limited partnership units of X LP, the Business and such other businesses and activities as the trustees of the Trust may determine, and holding investments and other direct or indirect rights in companies or other entities involved in the Business, including all activities ancillary or incidental thereto. The Trust has XXXXXXXXXX trustees, each of whom is a Canadian resident individual.

4. The Fund is a Unit Trust and a Mutual Fund Trust. The Fund is a limited purpose trust and its activities are restricted to, among other things, acquiring, investing in, transferring, disposing of and otherwise dealing with securities of the Trust. The Fund has XXXXXXXXXX trustees, each of whom is a Canadian resident individual. The Fund is administered by its trustees and by its administrator, X Co, pursuant to an administration agreement between, inter alia, the Fund and X Co dated XXXXXXXXXX.

5. The beneficial interests in the Fund are divided into two classes of interests, Units and Special Voting Units. The Units of the Fund are listed for trading on the XXXXXXXXXX Stock Exchange under the symbol "XXXXXXXXXX". All of the Special Voting Units of the Fund are held by Z Co.

6. Z Co is a taxable Canadian corporation and was formed on XXXXXXXXXX. Z Co is controlled by Individual.

7. The Governance Agreement provides for various matters relating to X Co, including the composition of its board of directors, and the management, control and operation of the Business and affairs of X LP. Pursuant to the Governance Agreement, all material transactions and agreements involving X LP must be approved by X Co's board of directors and, where those agreements involve Z Co, they must be approved by a majority of the independent directors of X Co.

8. Under the X LP Agreement, X Co has the authority to manage the Business and affairs of X LP, to make all decisions regarding the Business of X LP and to bind X LP in respect of any such decision. The powers of X Co include the authority to arrange for debt financing for X LP. X Co is allocated a share of the income or loss of X LP for each fiscal year of X LP and is entitled to be reimbursed by X LP for costs and expenses incurred by it in the performance of its duties under the X LP Agreement.

X Co owns XXXXXXXXXX general partnership units in X LP, which accounts for XXXXXXXXXX% of the outstanding general partnership units in X LP. X Co is allocated XXXXXXXXXX% of the taxable income of X LP for each fiscal year, unless no distributable cash flow is paid, payable or allocated to the limited partners with respect to a fiscal year, in which case X Co is allocated XXXXXXXXXX% of XXXXXXXXXX of the taxable income of X LP for that fiscal year on XXXXXXXXXX in that fiscal year. If X LP has a taxable loss in a given fiscal year, X Co is allocated XXXXXXXXXX% of XXXXXXXXXX of the taxable loss of X LP for that fiscal year on XXXXXXXXXX in that fiscal year.

9. X LP currently owes approximately $XXXXXXXXXX under the Existing Term Facility to a syndicate of lenders comprised of XXXXXXXXXX chartered banks: XXXXXXXXXX. The amounts borrowed by X LP under the Existing Term Facility were used by X LP to provide part of the funding necessary for the acquisition of the Business and to assist with the establishment of a capital expenditure pool.

10. In addition to the long-term financing available under the New Term Facility, X Co has also been canvassing short-term sources of financing in order to finance the working capital requirements of the Business, which fluctuate on a seasonal basis. Currently, the most favourable source of short-term financing is the Revolving Facility. As is the case with the New Term Facility, Y Co will be the sole borrower under the Revolving Facility.

11. The Term Lender deals at arm's length with X Co and X LP.

PROPOSED TRANSACTIONS

12. Y Co will be formed as a direct, wholly-owned subsidiary of X Co and will be capitalized with nominal share capital.

13. Y Co, X Co, and the Term Lender will enter into the Note Purchase Agreement on or prior to the closing date of the New Term Facility.

Y Co will be obligated under the Note Purchase Agreement to pay to the Term Lender various fees, including a commitment fee and a facility fee.

14. Y Co and Canadian Bank will enter into the Credit Agreement on or prior to the closing date of the Revolving Facility.

15. Y Co and X LP will enter into the Sub-Loan Agreement on or prior to the closing dates of the New Term Facility and the Revolving Facility.

16. Pursuant to the Note Purchase Agreement, Y Co will be obliged to pay certain customary costs and fees to the Term Lender in respect of the New Term Facility. In addition, the Note Purchase Agreement will include a typical "gross-up" clause which would require Y Co to make additional payments to the Term Lender to compensate the Term Lender for any withholding taxes, and certain other taxes, that may be exigible in connection with payments made under the New Term Facility.

17. Pursuant to the Note Purchase Agreement, on the closing date of the New Term Facility, the Term Lender will advance the Initial Draw to Y Co and Y Co will issue Term Notes to the Term Lender having an aggregate principal amount of US$XXXXXXXXXX (or the Canadian dollar equivalent) evidencing Y Co's indebtedness to the Term Lender.

18. Subsequent draws under the shelf provisions of the New Term Facility will be for up to an aggregate of US$XXXXXXXXXX (or the Canadian dollar equivalent). Such draws will be evidenced by Term Notes issued by Y Co at the time such draws are made.

The availability of draws under the shelf provisions of the New Term Facility will be until the earlier of (i) the second anniversary of the date of the Note Purchase Agreement (or, if such anniversary is not a business day, the business day next preceding such anniversary), and (ii) the XXXXXXXXXX day after the Term Lender shall have given to Y Co, or Y Co shall have given to the Term Lender, written notice stating that it elects to terminate the issuance and sale of Term Notes pursuant to the shelf provisions of the Note Purchase Agreement (or if such XXXXXXXXXX day is not a business day, the business day next preceding such XXXXXXXXXX day).

19. Each Term Note issued under the New Term Facility will rank pari passu and will mature XXXXXXXXXX after the date of original issuance of that Term Note.

20. Subject to Paragraph XXXXXXXXXX, under the New Term Facility, Y Co will not be obligated to repay any of the principal amount of a Term Note within XXXXXXXXXX years from the date of issue of such Term Note, except upon the occurrence of an event of default (all such events will be commercially realistic and beyond the control of Term Lender).

21. In the event of a Change in Control, Y Co will be required to make an offer to repay all issued and outstanding Term Notes. Such an offer to purchase must be made at a purchase price equal to the stated principal amount of the Term Notes plus accrued interest and a "yield maintenance amount" as determined under the Note Purchase Agreement. The failure of Y Co to make an offer to purchase the Term Notes upon a Change in Control will constitute an event of default under the Note Purchase Agreement.

22. Y Co will be entitled to prepay the Term Notes at any time, in whole or in part, in a minimum amount of US$XXXXXXXXXX and integral multiples of US$XXXXXXXXXX (or the Canadian dollar equivalent), at a price equal to the sum of the stated principal amount of the Term Notes plus accrued interest and a "yield maintenance amount" as determined under the Note Purchase Agreement.

23. The Term Lender requires that the Term Notes issued by Y Co be guaranteed by X Co, X LP, the Fund, and the Trust. X Co, X LP, the Fund, and the Trust will enter into the X LP Guarantee. After the date of the Note Purchase Agreement, if any person becomes a subsidiary of X Co, Y Co or X LP, such new subsidiary will enter into a subsidiary guarantee agreement in favour of the Term Lender.

24. Under the Sub-Loan Agreement, Y Co will loan the LP Initial Amount to X LP, which funds will be used by X LP to repay the Existing Term Facility and to fund the working capital requirements and possible future expansion of the Business. Y Co may from time to time make future advances under the Sub-Loan Agreement to X LP, with future draws obtained by Y Co under the New Term Facility or under the Revolving Facility. The loans under the Sub-Loan Agreement will be on substantially the same terms as the terms under which Y Co is borrowing under the New Term Facility and the Revolving Facility as to maturity date, principal amount and currency denomination. However, advances under the Sub-Loan Agreement will bear interest at a rate of XXXXXXXXXX% per annum in excess of the interest rates under the New Term Facility and the Revolving Facility, respectively.

25. The default provisions under the Sub-Loan Agreement will be subject to the default provisions under the X LP Guarantee. Y Co will earn a profit from the loans made under the Sub-Loan Agreement by virtue of the mark-up on the interest rate. In addition, as a condition of its agreement to make the loans to X LP under the Sub-Loan Agreement, Y Co will require X LP to reimburse Y Co for all of its fees and expenses incurred in connection with the Sub-Loan Agreement and incurred by Y Co under the New Term Facility and the Revolving

PURPOSE OF PROPOSED TRANSACTIONS

26. Although the Existing Term Facility does not mature until XXXXXXXXXX, X Co, in its capacity as general partner of X LP, has decided to refinance the Existing Term Facility in order to take advantage of current preferential market conditions for lower long-term financing interest rates. Accordingly, X Co has been considering replacement sources of financing for this purpose. In evaluating various options to refinance X LP's Existing Term Facility, X Co has the following key objectives:

(a) to borrow at the lowest cost of capital;

(b) to borrow from a single lender and thereby avoid the significant time and expense of having to deal with, and address the often divergent concerns of, multiple lenders with respect to financing issues that commonly arise between a borrower and a syndicate of lenders over the course of a long-term credit facility; and

(c) to obtain longer-term financing than the XXXXXXXXXX-year term applicable to the Existing Term Facility in order to achieve long-term financial stability for X LP and to reduce the time and expense associated with frequent refinancings.

27. X Co has canvassed various sources of long-term financing, both in Canada and the US, in order to secure financing that meets the above objectives. Currently, the most favourable source of long-term financing is the New Term Facility offered by the Term Lender, a US financial institution that operates in global capital markets. Under the New Term Facility, the Term Lender would provide the Initial Draw upon closing, thereby enabling the Existing Term Facility to be completely repaid and also providing funding for the working capital requirements and possible future expansion of the Business. In addition, the New Term Facility would include a "shelf" facility which would permit additional purchases of Term Notes by the Term Lender up to an additional aggregate principal amount of US$XXXXXXXXXX (or the Canadian dollar equivalent) provided certain conditions are satisfied under the New Term Facility at the time of such additional purchases.

28. Although the interest rate offered by the Term Lender under the New Term Facility is generally comparable to the interest rate that could be obtained from lenders in Canadian capital markets, the New Term Facility would allow X LP to meet all of its key borrowing objectives. Under the New Term Facility, the Term Lender would be the sole lender, thereby reducing the significant time and expense incurred where multiple lenders are involved. In contrast, based on X Co's discussions with several Canadian chartered banks, prevailing market conditions would very likely necessitate that a Canadian bank extending a long-term credit facility of comparable size and terms to that of the New Term Facility syndicate such a facility to multiple lenders, which would result in increased transaction costs and expenses for the borrower. As a result, being restricted to the Canadian market, where multiple lenders would be required, would increase X Co's overall cost of capital.

29. The New Term Facility would also allow for longer-term financing than is currently available under the Existing Term Facility. The shelf facility could be drawn on as necessary to provide additional financing for the Business, or the expansion of the Business, without significant incremental transaction costs or time expended in order to access funds. This would promote the long-term financial stability of X LP.

30. Having a Canadian corporation as the sole borrower under the New Term Facility would also facilitate borrowing at the lowest overall cost of capital. In addition, the legal nature of a corporation, in particular, its separate legal personality and limited liability, are well known to non-resident lenders who engage in financing transactions in global capital markets. Such lenders generally have considerable experience lending to corporate entities. In contrast, a typical non-resident financial institution likely has significantly less experience lending to an entity that is not a corporation, such as, in the case of X LP, a XXXXXXXXXX limited partnership. Accordingly, in circumstances where financing is being sought from a non-resident lender, it is preferable from a marketing perspective for the borrower to be a corporate entity. By borrowing through Y Co, a direct, wholly-owned subsidiary of X Co and a stand-alone financing vehicle for the Group, the activities of Y Co, as financing entity, can be segregated from X Co's role and functions as general partner of X LP. Similarly, as the Group is a public vehicle, using a separate financing subsidiary as borrower under the New Term Facility avoids the commercial complications that could arise if, for example, Z Co, a significant limited partner of X LP, was used to finance the Business.

31. In summary, the purpose of the proposed financing under the New Term Facility is to enable Y Co to obtain longer-term financing from a single lender at the lowest cost of capital, which financing proceeds will, in turn, be used by Y Co to make loans to X LP in order to repay its Existing Term Facility and to fund the working capital requirements and the possible future expansion of the Business. The purpose of the proposed financing under the Revolving Facility is to finance the working capital requirements of the Business, which fluctuate on a seasonal basis.

RULINGS

Provided that the preceding statements constitute a complete and accurate disclosure of all of the relevant warranties on page 1 of this advance income tax ruling, as well as all of the relevant Facts, Proposed Transactions and Purpose of Proposed Transactions, and provided that the Proposed Transactions are completed in the manner described above, our rulings are as set forth below:

A. By virtue of the exemption contained in subparagraph 212(1)(b)(vii) of the Act, no tax under Part XIII of the Act will be exigible in respect of any amounts paid or credited to Term Lender as, on account, or in lieu of payment of, or in satisfaction of, interest on the Term Notes issued under the New Term Facility, provided that at the time the amount is paid or credited Term Lender deals at arm's length with Y Co.

B. Subsection 15(2.3) of the Act will apply with respect to loans made by Y Co to X LP under the Sub-Loan Agreement.

C. Subsection 245(2) of the Act will not apply to the Proposed Transactions, in and by themselves, to redetermine the tax consequences confirmed in Rulings A and B.

CAVEAT

The above rulings are given subject to the general limitations and qualifications set out in Information Circular 70-6R5 issued by the CRA on May 17, 2002, and are binding provided that the Initial Draw occurs on or before XXXXXXXXXX.

These rulings are based on the Act in its present form and do not take into account the effect of any proposed amendments to the Act.

Nothing in this letter should be construed as implying that the CRA has agreed to or accepted:

(i) the GST implications of any of the Proposed Transactions, or

(iii) any other tax consequences of the Proposed Transactions or of related transactions or events that are not described herein.

Yours truly,

XXXXXXXXXX
Manager
Corporate Financing Section
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate